Yesterday when I was reading Times of India my eyes got stuck onto the ad of SBI which showed 17.01% p.a. in big highlighted box on its Tax Saving Deposits. At first instance I was amazed by the rate SBI is offering, like any other person I also thought that it is a rate of return but then suddenly I re-looked to confirm how come at this time bank can offer such a high rate which even companies deposits does not offer. Finally I found it is a new trick to fool small investors who does not know the difference between Annual Yield and Rate of Interest. So I decided to write brief article on Annual Yield and Rate of Interest to make small investors aware.
From above ad you notice that the amount you are investing is Rs.10,000. Tax benefit you get immediately is Rs.3,090 (considered under Tax Bracket of 30%). So your effective investment is Rs.6,910. For this effective investment you will get return of Rs.15,605 (for senior citizens) and Rs.15,415 (for others). Rate of Interest they are quoting as 9.00% p.a. for seniors and 8.75% p.a. for others. Then how this effective annual yield is 17.39% and 17.01%?
Before knowing the actual annual yield rate you need to understand the term Annual Yield and Rate of Interest.
Basically Rate of Return or Rate of Interest is quoted without considering the Tax Effect. If you see the advertisement Rate of Interest quoted is 8.75% p.a. i.e. if you start compounding Rs.10,000 with 8.75% yearly you will reach to the approximate maturity amount.
|Compounding||10000 X (1+.09)5||10000 X (1+.0875)5|
* Figures are Approximate
On the other hand Annual Yield is calculated by considering Tax from the beginning till the end. In the advertisement of SBI, only Tax effect at the beginning is considered which is only half true, tax effect at the time of maturity is totally ignore.
So the correct Effective Annual Yield after giving proper tax effect comes to:
|Immediate Tax Savings*|
|Effective Investment (A-B)|
|Maturity Amount of Original Investment|
|Total Pre-Tax Benefit on Deposits (D-C)|
|Rate of Interest|
|Effective Annual Yield [(E/5)/100]|
|Total Interest Earned (A-D)|
|Tax on Interest*|
|Maturity Amount Post Tax (D-I)|
|Total Post Tax Benefits (J-C)|
|Effective Annual Yield Post Tax[(K/5)/100]|
* Assuming a Tax Bracket of 30%, effective tax rate 30.9%
The above annual yield rate is still better but one has to know all the hidden facts before investing.