Personal finance is all about managing, investing and saving money. Other than these, one other thing needed is to know the exact value of your money because various external factors can have an impact on the value of your money. Another reason is that gains and losses are not simple functions and can change under different circumstances. Therefore, it is important to know how to calculate certain figures to understand the actual worth of an investment.
One of the quite popular forms of investment in Kenya is fixed deposit. Before investing on fixed deposits, the depositors should be aware not only of nominal interest rates but also of how nominal rates are used in calculating total interest amount. Sometimes, calculations may be done in a different way or using a different formula. Even the same formula can be used differently to arrive at a certain result.
By definition Fixed Deposit (FD) is an investment product which allows you to invest a lump of money for a fixed time period and at a fixed rate of interest. When you open a fixed deposit with bank then you are lending money to the bank and it pays you interest. Applicable interest rates will be given as on the date of receipt of the funds by the bank and is fixed for the specified duration.
The interest amount paid on the fixed deposits directly depends not only on the rate of interest applicable to such deposits but also on a number of other factors, including the method used to calculate the same. Though there has been a lot of discussion in the literature on the quantum of the rate of interest, there appear to be no discussions on the method of calculating such interests. This could be because it was thought that the method of calculation should have been one and only one. The methods of calculating interest described here are some of the more common methods in use. They indicate that the method of interest calculation can substantially affect the amount of interest paid, and that depositors should be aware of this to avoid dispute arising on the payment date.
The three most common day count methods are outlined below.
- Actual/actual, is the most intuitive and precise day count scheme. To determine the number of days between any two dates, the actual number of days, including the effect of a leap year, is counted.This method is highly recommended by International Capital Market Association(ICMA) rule 251 on accrued interest calculation.
- The Actual/365 (fixed) method counts the actual number of days of a FD, but the denominator (used to calculate a daily interest rate) will exclude the extra day in a leap year. Thus, a daily interest rate is always the yearly rate divided by 365.
- Actual/360 is a slightly odd method, which counts the actual number of days during which a FD is outstanding and calculates the interest rate based on a 360-day year this type of count obviously benefits the lender.
The first step lets calculate how much you will earn on on six month fixed deposit of KES 1,000,000 effective 17th Dec 2015 at a rate of 9% p.a.
The actual days per year are counted (leap year 366 days, “normal” year 365 days). If a contract runs over one years (one of them being a leap year), the interest calculation is divided into two parts, over the actual number of days the Deposit runs.
Factor= Days not in Leap Year/ (365) + Days in Leap Year/ (366)
|Principal Amount||Basic rate||Tenure(Days)||Calculated Amount *|
* Subject to deduction of 15% withholding tax.
Based on the calculations we realized a variance as shown in the below table;basis of comparison is actual/actual.
In conclusion the method used in calculating the accrued interest will affects the amount paid to the customer.