Why Compounding Frequency Changes Your Return

Every row is a 7% deposit. The difference between the best and worst is ₹1,508 over five years on ₹1 lakh — real money, but not transformative.

The mechanism is straightforward: interest credited earlier starts earning interest itself. The more often that happens, the more interest-on-interest accumulates.

The effective annual yield converts any compounding frequency into an equivalent yearly rate, so two products can be compared directly. The formula is ((1 + r ÷ n)ⁿ − 1) × 100, where r is the nominal rate as a decimal and n is the number of compounding periods per year.

A deposit quoted at 6.95% compounded monthly beats one quoted at 7.00% compounded yearly. Comparing headline rates would tell you the opposite.

It is worth being honest about the size of this effect. Moving from yearly to monthly compounding on a 7% deposit adds about 0.23 percentage points of effective yield.

By comparison, holding the deposit for ten years instead of five roughly doubles the interest, and a one percentage point higher rate adds far more than any compounding frequency change.

Compounding frequency is worth checking when two products are otherwise similar. It is not worth choosing a materially worse product to obtain.

• Credit card balances compound monthly at rates far above any deposit rate. The same mechanism that slowly builds a deposit rapidly inflates a revolving balance.
• Loans quoted on a monthly reducing balance compound monthly by definition.
• Late payment charges added to a balance then attract interest themselves.
• The asymmetry is important: the frequency effect is modest on a 7% deposit and severe on a 40% credit card balance.