Compound interest - One of the options for calculating remuneration for the use of borrowed funds in a bank deposit. Many financial institutions offer such deposits as an ideal tool for financing. Is it really?
Principle of operation
So that the client can make a deposit, the bank opens an account for him, to which the funds are transferred. The size of the amount and frequency of transfers are indicated in the contract. From the moment of the first transaction, as a rule, funds become inaccessible to the client. Their return will occur either in case of early termination of the contract, or at the end of its validity.
Deposits with interest capitalization - bank deposits, in which, after a certain period, the amount for settlements increases. For a better understanding of the essence of the issue, basic knowledge of mathematics is needed. There is a main (initial) amount (PV). Interest is accrued on it at a certain rate (r) for a certain period (t). After each period of time, the accumulated money is added to the main amount, that is, the basis for calculating the fee for the use of borrowed funds increases. This is the capitalization of interest. In a simple scheme, the fee for using borrowed funds does not increase the basis for settlements.
How does interest capitalization occur?
The conditions for servicing contracts are determined by the following parameters:
- Deposit term.
- Interest rate.
- The time base for the calculation (360 or 365 days).
The formula for interest capitalization is as follows: FV = PV * (1 + r)t.
Under the terms of the contract, the interest rate is usually indicated annually, and an increase in the base for settlements can occur more often. For example, every 1, 3, 6, or 12 months. The calculation of interest capitalization is as follows:
% = p * d / y, where
p - rate under the terms of the contract (annual);
d - period of capitalization (days / month);
y is the number of days / months in a year.
Example. For a deposit of 1000 y. e. Monthly compound interest is accrued at a rate of 10% per year. The final deposit amount (FV) will be:
% = 0,1*1\12 = 0,0083.
FV = 1000 * (1 + 0.0083) * 12 = 1104.27 cu
Net income will be: 1104.27 - 1000 = 104.27 cu
And now we calculate the final deposit amount on the condition of simple interest: FV = 1000 * (1 + 0.1) = 1100 у. e.
We place accents
Interest capitalization is a rather complicated process in which time is of great importance. The longer the money is deposited with compound interest, the more capital will grow. Most likely, the bank will offer you its own calculator for settlements. He conducts all of the above operations with a single keystroke. But you can always check the accuracy of the calculations by substituting the data in the formula.
Rates on deposits with capitalization are lower than with simple interest. The difference in 1 pp can even turn out to be significant. This can be seen from the example presented above. If you increase the rate by 11% or 12% and make settlements without capitalization, the amount receivable will still be higher. To choose more favorable terms of deposits, calculate the actual yield of the deposit for all conditions of deposits.
Since compound interest is accrued only based on the results of a certain period, deposits with frequent capitalization are more profitable. The worst option is a contribution in which an increase in the settlement base occurs only after a year of service. Even worse, if the deposit period is 365 days. The more favorable the conditions, the more often the interest is capitalized.Specialists recommend that before concluding an agreement, ask the employee to calculate the yield for the same period on different deposits.
Separately, it is worth noting the features of foreign currency deposits with capitalization. Such a product is extremely rare in the banking market. But its conditions are far from always beneficial to investors. When concluding such agreements, banks often use the following scheme: the deposit is credited in foreign currency, and the earned interest - in the national currency. Profit of a financial institution - the difference in exchange rate, which may be recorded in the contract with the phrase “at the time of payment”. This figure will always be higher than the established Central Bank, and during the conversion, the bank may additionally withdraw the commission for cash settlement services.
Depositor Tips
Any client can independently place a deposit with capitalization. You only need to find offers on deposits with a monthly interest payment and the possibility of replenishment. That is, during the execution of the contract in the bank branch, you must immediately inform the employee about your desire to transfer all accrued interest immediately to deposit account. This option has several advantages:
- The investor independently decides whether he will fully or partially capitalize interest. Some customers prefer to spend part of the "earned" amount on other needs.
- When using simple interest, the rate is higher than with capitalization. Given the above scheme, the depositor lends his funds to the bank on more favorable terms.
- In some institutions, the deposit replenishment process can be automated. But this service is paid.
Read the contract carefully
The ability to unilaterally change the rate can be prescribed by the bank directly in this document. In such cases, the client is not insured against the risk of a decrease in profitability. There is another situation. The bank may prescribe that after changing the current deposit rates, the client must visit the branch within a certain time (7 days) in order to sign an additional agreement with the new conditions.
If such a document is not provided, the contract may become null and void. The catch here is that the bank may not inform customers about the change in rates. Meanwhile, interest on the deposit ceases to accrue. That is, all the remaining time the bank will use the funds almost for free.
Other financial instruments
Why invest in stocks, bonds and mutual funds when you can open a deposit with compound interest? In the long run, profits will be colossal and without much risk. The probability of bankruptcy of a credit institution is less than that of companies in rapidly developing sectors of the economy. The fact is that stocks and other securities generate more income over the same period of time. Therefore, when choosing the direction of financing, each investor independently decides what is more important for him: to save money, but get less profit, or risk capital.
Summary
The bank pays interest for the use of attracted funds. There are two schemes for such a procedure: simple and complex. The second is more profitable with a long term deposit. The accrued amount is added to the original, increasing the basis for calculations. This is what capitalization of interest means.
