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How do Banks Calculate Interest on Savings Accounts in India?

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How do Banks Calculate Interest on Savings Accounts in India?

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How do savings banks calculate interest on your savings account? That’s not a secret everybody knows yet. Let's give it a shot, though, for whatever it's worth.

A trip back in time: Interest calculation before April 2010

Before April 1, 2010, the system of interest calculation on savings accounts was very different from what we have today. Back then, the Reserve Bank of India had two key regulations for interest calculator and credit: 

  • Banks had to calculate interest on the minimum balance in an account between the 10th and the last day of each month.
  • This interest had to be credited to the account only if it was Re. 1 or higher.

This wasn’t a very fair method of calculating the interest on savings account balances, because it only considered the minimum balance in the account. 

So, for instance, if you held Rs. 10,000 in your account for most of the month, but withdrew Rs. 9,000 just before the month end for some emergency needs, you only earn interest on the remaining Rs. 1,000. 

Not very beneficial, right?

Let me take you through two examples for more clarity on this method of interest calculation. Say there are two account holders, each having savings accounts in the same bank. The rate of interest on their savings accounts is 4% per annum.

Prior to April 2010, this is how they would have earned interest, based on their account balances as shown in the table below.

Here, the first account holder held more money in their account for most of the month. Still, it is the second account holder who earns interest on a higher amount. This is because banks only took the minimum account balance into consideration.

Thankfully, the central bank recognised this discrepancy and changed things up a little from April 1, 2010.

How do banks calculate interest on savings accounts today?

Here’s a quote from the RBI’s own notification dated April 24, 2009[1] —

“...payment of interest on savings bank accounts by scheduled commercial banks would be calculated on a daily product basis with effect from April 1, 2010.”

From then till now, banks have been calculating interest using the daily balance method. 

This means that the interest rate on your savings account will be applied on the outstanding balance at the end of each day. So, you will receive the full benefits of the amount you maintain in your account. Even if you have to withdraw a huge portion of your balance to meet some emergency needs, you need not worry about losing interest income. 

Check out the formula used to calculate the interest on your everyday balance —

Want more clarity on this? Why don’t we take up the case of the two account holders in the previous and see how much interest they’ll earn. 

The outstanding balance changes over the course of the month. So, how do banks calculate interest in this case? Let’s see.

Now, in case of the second account holder, here is what the account statement for the month of January looks like. 

And how do banks calculate interest in this case? Let’s find out.

See how the first account holder, who generally held more money in the account during the month, earns interest accordingly? This is why the new method of calculating interest on savings accounts is much more beneficial to depositors.

What about the interest credit? When does that happen?

Now that you know how banks calculate interest on your savings account balance, you may have a new question on your mind. If the interest calculation happens daily, when does the interest get credited?

Well, the RBI has regulations that require banks to credit the interest to your account at least on a quarterly basis. This means banks can also choose to credit the interest to your account every month, if they wish to. 

And once that interest is added to your account, it is also considered as a part of the balance. You know what that means, right? You earn interest on that interest. All thanks to compounding!

Is there an easy way to calculate the savings account interest?

Understanding how to calculate interest may be easy. But doing it manually each time? Not so much. Thankfully, you can just make use of a savings bank interest calculator to quickly check how much interest you’ll earn each month or each quarter — depending on your bank’s policies. 

Frequently Asked Questions (FAQs) 

1) Does a savings account pay interest monthly?

Banks generally pay out the interest on savings accounts on a quarterly basis. However, they can choose to pay the interest monthly, if they wish to. Check in with your bank and find out how often they pay out the interest on savings accounts. 

2) How do you calculate monthly interest on a savings account?

The interest on your savings account is not calculated on a monthly basis. It is calculated each day, according to the formula shown below:

Interest = Daily balance * Rate of interest per annum * Number of days/365

3) Do I have to pay tax on the interest earned from my savings account?

Yes, the interest you earn on your savings account is taxed according to your income tax slab rate. But under section 80TTA of the Income Tax Act, 1961, you can claim savings account interest up to Rs. 10,000 as a deduction from your total taxable income. 

4) At what frequency is the interest on a savings account calculated?

Your bank calculates the interest on your savings account balance each day. So, your daily balance determines the interest calculated for that day. If you deposit money into your account today, you will earn more interest, and if you withdraw some funds today, your interest for this day will accordingly reduce. 

5) Is the interest calculated on a savings account simple or compound interest?

The interest you earn on your savings account is compounded. This means that once the interest for a period is credited to your account, it is also considered as a part of the balance and used to compute the interest thereafter.

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