Short answer: Compound interest earns interest on your interest. On 1,00,000 at 8% for 5 years, simple interest pays 40,000, while interest compounded every quarter pays 48,595.
Two fixed deposits with the same interest rate can pay different amounts. The difference is whether, and how often, interest is compounded.
Simple interest
You earn interest only on the amount you deposited.
Interest = amount × rate × years
1,00,000 at 8% for 5 years earns 40,000.
Compound interest
Each time interest is added, the next interest is calculated on the larger balance. The same 1,00,000 at 8% for 5 years earns:
- Compounded yearly: 46,933
- Compounded quarterly: 48,595
- Compounded monthly: 48,985
More frequent compounding pays a little more, but the biggest jump is from simple to compound at all.
Tip: To compare deposits fairly, ask for the effective annual yield or the maturity amount, not just the headline rate.
Things that change what you actually get
- Payout option: if interest is paid out to you every quarter instead of being added to the deposit, it does not compound.
- Tax: interest is usually taxed, and banks may deduct tax at source. Compare returns after tax.
- Breaking early: withdrawing before maturity usually means a lower rate or a penalty.
- Inflation: if prices rise faster than your after-tax interest, your money buys less at the end.
Questions people ask
Q: Is monthly compounding always better?
A: At the same rate, yes, slightly. But a higher rate compounded quarterly can beat a lower rate compounded monthly, so compare maturity amounts.
Q: How long does it take to double my money?
A: Divide 72 by the yearly interest rate. At 8% that is about 9 years. See our post on the rule of 72.