When you look at the Bank advertisements about their Bank FDs rates they show two returns. One is the interest rate and another rate is annualised yield. You also notice that this annualised yield will go on increasing drastically as the term of the deposit increases. So what to follow? Annualised yield or CAGR returns?
What is Annualised Return or Annualised Yield?
Before proceeding further let us understand what do you mean by Annualised Returns. Suppose a Bank offering 9% return on 10-year deposit. Usually this annual interest will be quarterly compounding. So effective yearly yield will be 9.3%. So if someone invests Rs.100 in this deposit, then at the end of year his return will be 109.30. Same way at the end of 10th year his/her investment will grow to Rs.243.51. So the difference between the invested amount of Rs.100 to the maturity amount of Rs.243.51 will be Rs.143.51. They divide this into 10 years which will be 14.351. This growth is called as annualised return of 14.351 %.
Simple formula to calculate the Annualised return will be
(Maturity Amount-Invested Amount)/No. Of Years Invested.
What is CAGR?
CAGR or Compounded Annual Growth Rate is the actual indicator of return. This is the common practice and best practice used to analyse the return on any investment. That is why SEBI made it mandatory to show CAGR only for mutual fund products while showing a historical return.
This is calculated using the below formula
CAGR=( EV / BV)1 / n – 1
Where EV=End Value, BV=Beginning Value and n=number of years.
So let us take the same example of Rs.100 invested in FD which is giving us 9% quarterly compounding for 10 year period then CAGR will show the return of 9.31%.
So what is the actual return calculator?
Let us decide this by common man’s understanding. Suppose a person who sees the advertisement which states annualised yield of 14.351% and invested in 10 year FD. After two years if he wants to redeem the FD then his thinking is he will get Rs.14.351 will going to add every year for the investment of Rs.100 which after two years according to him will be Rs.100+Rs.28.7=Rs.128.7. But it is not the case, instead he will receive only Rs.119.48 (excluded the penalty clause for the better understanding purpose). But at the same time if we put the value in CAGR calculation then the return after two years will show 9.31% only. Hence the actual return calculator will be CAGR but not the Annualised Return.
Banks use the trick of showing both interest rate as well as annualised yield to lure the customers. Because annualised yield will be a simple interest growth rate but not the compounding and will show higher returns than CAGR.