Sunday, August 07, 2011

Interest Rates and Maturity Yields

An interesting discussion with my brother yesterday led me to writing this post. And since I had a gag order at home for not discussing this anymore in the open, I had no other option! Anyway, the topic of discussion was about an investment scheme that offered to double the amount invested in 5.5 years. With interest rates being high, not bad I thought. But, the confusion (and the subsequent  argument) arose because the scheme was offering returns of 18%+!!

There has to be something wrong (or fishy)! I was sure, that as a rule of thumb, at 10% interest rate, the time taken to double an investment is around 7 – 7.5 years. But 18% returns was mighty high AND 5.5 years felt too long a time period for such returns.

 If we take the Rule of 72 or better, have a  look at this calculator, it would roughly take 4 years for the money to double at 18% returns. And currently banks are offering, at the best, an interest rate of 10% per annum. So what are we talking about here?

Well.. as suspected, it turned out that all of these are correct!! Such a scheme exists. It doubles money in 5.5 years. The returns given is 18%+. But the difference here is how the “returns” part of the scheme is arrived at and how it is sold/ marketed.

The returns of 18%+ is actually the yield offered by the scheme and NOT the interest rate. Usually investors compare investment products in terms of interest rates, so that one can compare the rates and choose one that gives the best returns. But being a private player and may be to make the sale easy, the investment company has devised a clever marketing tactic of enticing the investor with the yield expressed as an impressive % (instead of interest rates). In real terms this would be like comparing apples with oranges. Yield and interest rates are indicators of returns, but both are different.

To simplify things, this is what the scheme offers:
  • Investment amount = Rs. 60,000
  • Maturity term = 5.5 years
  • Yield = 18.2%
  • Annual interest = 13.4%

(for detailed calculations, please check this spreadsheet)

So is this good or bad?
Well.. if we compare the returns (annual interest of 13.4% vs. 10% offered by FDs), the scheme is good. But one also need to be aware of associated risks. The additional return offered by the scheme has to considered as the risk premium. The more risks the investor is willing to take, the better is the returns. Why else should they market it with 18.2%, when the interest rate itself is a good 13.4%?

Disclaimer: The views posted in this blog are my own and are based purely on my own way of assessments. Readers are requested to consult with their financial/ insurance advisers before making any investment/ insurance decision, do their own due diligence and validate factual information. 


joseph08 said...

Sir, cld u let me the NAME of the company that offers such an amazing INterest just after 6 yrs..?? uhnakyu very much sir

Nidhi Singh said...

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