Compounding Frequency

Investments

Compounding frequency determines how often interest is calculated and added to principal. Daily compounding is better than monthly, which is better than quarterly, which is better than annual -- even at the same stated annual rate. The more frequent the compounding, the higher the effective annual return.

In detail

Effective Annual Rate (EAR) for 7% stated rate:nAnnual compounding: 7.00%nQuarterly compounding: 7.19%nMonthly compounding: 7.23%nDaily compounding: 7.25%nnFD compounding: most bank FDs compound quarterly. Some monthly. Check the scheme documents.nSavings account: daily balance calculation, quarterly credit (or monthly in some banks).nMutual funds: daily NAV change = daily compounding effectively.nPPF: annual compounding (March 31 interest credit).

Formula

Effective Annual Rate (EAR) = (1 + r/n)^n - 1nr = stated annual rate, n = compounding periods per yearnQuarterly: (1 + 0.07/4)^4 - 1 = 7.186%nMonthly: (1 + 0.07/12)^12 - 1 = 7.229%

Real-life example

🇮🇳 India example

Bank A: 7% FD, annual compounding. Bank B: 7% FD, quarterly compounding. On Rs 1L for 5 years:nBank A: Rs 1L x (1.07)^5 = Rs 1,40,255nBank B: Rs 1L x (1.0175)^20 = Rs 1,41,478nDifference: Rs 1,223 from compounding frequency alone on same stated rate. For Rs 10L over 10 years: difference is Rs 18,000+.

Frequently asked questions

Which is better: annual or quarterly interest payout? ▼

For reinvestment: take interest at maturity (compound continuously at the FD rate). For regular income: take quarterly payout but reinvest in another FD. If you spend the quarterly interest, effective compounding is zero -- you only benefit from the stated rate annually. Choose maturity payout for wealth building; quarterly payout for income needs.