Don’t confuse yields with interest rates

Last week, a reader pointed me to fixed deposits from Avon Corporation, and my eyes naturally gravitated towards the highest number in the table viz. 14.19% yield  p.a. for a 3 year fixed deposit. On the face of it this looks quite high, but that's because your reference is usually a fixed deposit interest rate, which is different from this yield. It is important to understand this difference because there are a lot of private companies that offer fixed deposits, and they usually do advertise the effective yield. I don't write about company fixed deposits a lot, but when I checked a 2009 article about Tata Motors fixed deposit – I saw that they used the same annual yield as well. Usually companies give you two options: Periodic interest payment Cumulative option The periodic interest option is usually straightforward, as they advertise the rate of interest you will get for your deposit. However, the cumulative plan becomes confusing because they advertise an interest rate and an annual effective yield. Let's use the numbers given in the Avon example. They say that the minimum investment is Rs. 5,000, tenure is 3 years, interest is compounded quarterly, and the yield per annum is 14.19%. So, what does that mean – are you getting 14.19% interest per year which is then re-invested for you? No, absolutely not. Their brochure tells you that  you're getting 12.00% interest rate for the 3 year maturity period, so where does the 14.19% number come from? Since, this is a cumulative option you won't get any interest payments, and get a lump – sum payment at the end of three years. Use the Compound Interest calculator to calculate how much you will get at the end of 3 years. This gives us Rs. 7,128.80 at the end of 3 years. So, for Rs. 5,000, you get interest of Rs. 2128.80 for 3 years. Divide that by 3 to get the annual interest – Rs. 709.43. And (709.43 /5000) x 100 = 14.19%. This is your annual effective yield. Conclusion You can't compare this 14.19% with the interest rate that banks normally show because that's like comparing apples and oranges. This number is high only because it has been compounded for 3 years, then divided equally by three years, and you use the initial principal of Rs. 5,000 as base. If you were to get a fixed deposit with a bank at 12% for a year, and re-invest that money again for two more years you will get the same effect. I think this post is important for people who are interested in depositing money with companies, so please keep the distinction between yields and interest rates always in your mind, and don't confuse one with the other.

Source: OneMint

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Yours

Murali........