Interest income on savings account set to rise

April 5th, 2010 Rosita Leave a comment Go to comments

Saving bank account holders will see a rise in interest income from April 1 onwards. This
is not because interest rates have changed. It still stands at an abysmally low rate of 3.5%
p.a., but what has changed is the way banks will now calculate interest income on the
savings account. RBI has notified banks to adopt a new mechanism for calculation of
interest from April 1, 2010 onwards, whereby interest will have to be calculated using the
“daily balance method.”

What is the “daily balance method”?

Interest income will be calculated @ 3.5% p.a. using the day end balance. Let’s look at
an illustration to see what this means and how this methodology will work.
Illustration
Below is a snapshot of the transactions executed by Mr. Atul, pertaining to his saving
bank account for the month of April.

Date Particulars Deposit (Rs.) Withdrawal (Rs.) Balance (Rs.)

1-04-2010 Opening Balance 50,000
3-04-2010 Salary credit 30,000 80,000
21-04-2010 Fixed Deposit 50,000 30,000
30.04.2010 Closing Balance 30,000

Interest calculation would be as under

Balance * number of days *%Interest per annum / number of days in a year

For the month of April interest calculation would be as under

Days Balance (Rs.) Interest amount (Rs.)

1-04-2010 to 2-04-2010 = 2 days 50,000 50,000*2*(3.5/100)/365 = Rs. 10
3-04-2010 to 20-04-2010 = 18 days 80,000 80,000*18*(3.5/100)/365= Rs. 138
21-04-2010 to 30-04-2010 = 10 days 30,000 30,000*10*(3.5/100)/365= Rs. 29
Total interest for April Rs. 177

Mr. Atul will receive Rs. 177 as interest income for the month of April.

How is the new method any different from the earlier method?

Under the previous methodology, banks would compute interest @ 3.5% p.a. on the
lowest available balance in the account between the 10th and the last day of the month.
This meant that if you withdrew money any time after the 10th day of the month, even if
it meant the last day of the month, you would end up losing interest as your account
balance would reduce and interest would be calculated on the lowest balance. Also, any
deposit made by you during the same period (between the 10th and the end of the month)
would not make any difference to the interest income calculation as a higher balance does
not impact it.

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For the account holder, it would not make economic sense to have a high account balance
on an average because if the account balance falls even on a single day between the 10th
and the last day of the month, that low figure would be used for interest calculation
resulting in loss of interest income.

To understand the impact monetarily, let us see what Mr. Atul’s interest earnings would
have been under the old method of interest calculation.

The lowest balance between the 10th and the 30th of April was Rs. 30,000. So Mr. Atul
would receive interest to the tune of Rs. 86 {Rs. 30,000*30*(3.5/100)/365}. So in spite
of having a balance much higher that Rs. 30,000 for most of the month, Mr. Atul would
end up losing interest because, he withdrew on the 21st of the month thereby reducing the
balance in his account.

From the account holder perspective, this methodology of calculating interest income was
unfair as he would not get the advantage of having a high balance on an average in his
account.

What does the new methodology of interest calculation mean for account holders?

• Interest income on the savings bank account will rise- Mr. Atul will receive an
additional interest of Rs. 91 (Rs. 177 – Rs. 86) under the new method as against
the old method of interest calculation
• Fluctuations in the account will not have a disproportionate impact on the interest
earned
• Reduces the worry of timing withdrawals and deposits
• No need to look at other avenues for parking funds for short intervals- liquid
funds, short term fixed instruments

The new mandate by RBI is a feather in the cap of the investor community. After all,
shouldn’t you get interest on the actual amount you have in your savings account rather
than on the minimum balance?