You may think of a fixed deposit as lending money to a bank or an NBFC. When you invest in an FD, the financial institution guarantees to return the invested sum at the end of the tenure, known as the maturity period and pays you interest for it. The bank may use this money to lend to other borrowers and charges them interest for the same. A portion of this interest is passed on to you.

The interest offered depends on the tenure or maturity period of the FD. A 7-day fixed deposit will carry a lower annual interest rate compared to a one-year FD. This is to compensate for the time risk of money. Simply put, a rupee today is more valuable than the same rupee a year from now. This is because inflation pushes up prices over time. A rupee will buy you more goods today than it will a year from now. An investor needs to be compensated for this.

You can choose to reinvest the interest or receive an interest amount periodically in your bank account.

1. Cumulative FDs pay you the interest and the principal at maturity. The interest is reinvested every year. This means that you will not be eligible to receive a regular interest pay-out instead of receiving a lump sum at the end of the FD tenure. The cumulative FD option may be suitable for you if you do not need a regular stream of income. Under this option, you will also benefit from the power of compounding, as the following year’s interest will be calculated on the principal plus interest of the previous year.
2. Non-cumulative FDs will pay you interest at fixed intervals. You could choose to receive interest payments monthly, quarterly, half-yearly, or annually, depending upon your needs. This will give you a regular stream of income. However, the downside of non-cumulative FDs is that you will lose out on earning interest on interest.