Savings Account Interest Calculations
You should consider yourself lucky for being an Indian and not a Danish. At this very moment, if you happened to have been a Danish, living in Denmark with a savings bank account in a small bank named FIH Erhvervsbank, you wouldn’t have the advantage of earning interest on your saved money. Instead, you would actually be paying interest to the bank for keeping your money!
As horrible as it may sound, it is actually true! The aforementioned bank in Denmark is actually charging its customers an interest of 0.5% on savings accounts effective March, 2015. The reason is a grim economic scenario where the country is taking the heat of ever increasing threat of economic stagnation and dwindling prices (deflation).
In India however, despite the deflationary pressure, banks are still paying interests to all their savings account customers. How or why they are paying interest or exactly why the Danish bank is charging interest are discussions not meant for this article. As the title suggests, we are here to discuss how the interest rates are calculated by banks.
The only reason we mention the Denmark scenario is that if you are whining about low interest rates or low interest earnings on your savings bank account, you should stop doing so because what you are receiving is actually free money. No matter how less or insignificant the interest earnings are, you are still lucky enough to at least get the free treat. Danish people are paying out of their hard earned money and that’s something people don’t really like.
Coming back to the original topic of the article, how exactly are banks calculating the interest rates on savings accounts? Well, before we move forward, what you must know about interest rates on savings account is that the interest rates offered by the different banks are the rates that they themselves decide on. This is a result of deregulation of savings interest rates by Reserve Bank of India. This however was not the case. Once the saving interest rates were regulated and set by Reserve Bank of India. It was a mandate that no bank can pay any more than 4% interest per annum.
Once the regulator pulled away the mandate, banks freely decide on how much interest they are willing to pay to their customers. Currently, the savings interest rate hovers around 6% per annum. This deregulation did do one good thing – it helped the banks to become far more competitive than before and at the end, customers like you and I benefit from higher interest earnings.
Now, our objective is to know exactly how the banks calculate savings account interest rates. There are two distinct approaches. One of them is obsolete because of another RBI mandate. The new one in place is far better and more beneficial from a customer’s perspective. The obsolete one was in favor of banks.
The Obsolete Method of Lowest Balance
Before April 2010, banks used to calculate interest rates every month based on the lowest available balance in a savings account between the dates 10th and 30th of any given month. So, a withdrawal between those two dates was a bad choice for customers.
Let us take a simple numerical example to explain this method:
Let us say that Avani holds a savings bank account where she earns 4% per annum interest on whatever money she saves in her account.
Let us assume that between 1st and 21stof a month, Avani maintained a balance of INR 58,000.
Let us assume that during this period, Avani managed to make some cash, say INR 22,000 by selling some of her handmade gifts items over Esty online shop.
She deposits the cash in her savings account on 22nd of the month, which increases her total savings account balance to INR 80,000.
Three days later, on 25th of that month, Avani decided to make some for gifts for selling and withdrew INR 40,000 for purchase of raw materials. This reduces the balance in her savings account to INR 40,000. She withdraws another INR 25,000 for purchasing an air conditioner. This further reduces her account balance to INR 15,000. No further transactions take place for remaining days of the month.
At the end of the month, the bank sits to calculate the interest Avani should earn on her savings account balance. Since the bank will take the lowest balance in account between the dates 10th and 30th, the bank will only consider the balance of INR 15,000 as the savings account amount that will earn interest rates.
This is equation the bank will use:
So, at the end of the month, what Avani gets is just INR 49.315 as interest earning despite the fact that her account savings peaked at INR 80,000 on 22nd of the month.
The Current Method of Daily Balance
Since April 1, 2010, according to RBI mandate, the banks were forced to redo their interest calculation methods, making them more pro-customer. As a result, the interest rates are now calculated on a daily basis.
So, keeping the above example of Avani intact, let us find out how much interest earning she is entitled to over a period of 1 month. For this purpose, we need to calculate the balance each day. As per our example,
For 21 days [i.e. from 1st of the month to 21st of the month], the total balance in the account was INR 58,000. This means that the balance for each day was INR 58,000.
So, interest earnings for first 21 days will be:
For 3 days [i.e. from 22nd of the month to 24th of the month], the total balance in the account was INR 80,000. This means the balance for each day during those 3 days was INR 80,000.
So, interest earning for those 3 days will be:
For last 6 days [i.e. from 25th of the month to 30th of the month], the total balance in the account was INR 15,000. This means the balance for each day in last 6 days was INR 15,000.
So, interest earning for last 6 days will be:
So, total interest earned by Avani over 1 month = interest earnings for first 21 days + interest earnings for 3 days + interest earnings for last 6 days = INR (133.479 + 26.301 + 9.863) = INR 169.643.
So, with new method of interest rate calculations for savings account, Avani earns about 3.5 times more interest than the previous and obsolete method of interest calculation.
You need to know that savings account interest rates vary from one bank to another but there isn’t too much of difference. Depending on how much money you save in your bank account, the amount of interest money you earn can vary significantly. Also remember that some banks actually offer way more interest rates for savings about INR 100,000. So, when you are thinking of opening a savings bank account, consider the savings account interest rates offered by the banks as one of the major factors. Of course, other factors like bank location, number of branches, number of ATM’s, online services etc. should also play a vital role. All we want to say is, Play Wise!