Fixed deposit was invented, so banks knew for sure, how long they have access to the money vested in the same, so banks could lend the money to corporates or individuals. This is even the case now with small players. However, big players like SBI and other banks that have surplus money need not know the commitment timeof the deposite - becasue they already have plenty of money to give loans. So, such banks started a new type of bank account called auto sweep account, in which your money is automatically vested in fixed deposit and you will be paid an interest that is equal to the interest of the fixed deposit in the bank. Whenever you withdraw the money from an ATM, a portion of the fixed deposit would be broken so as to server your ATM withdrawal request. In general, the amount thus broken will be a in multiple of Rs 10,000/- as of 2013. At least I am sure that it is 10K for SBI.
Interest on fixed deposit is generally higher than that of a savings account. It would range, based on the duration of the fixed deposit - which generally ranges from 6pa to 10pa or even more. State bank of India is know to give the highest intersest rates for low-tenure fixed deposite, for example, for a 7days fixed deposit, you would get 7% rate of interest, which no other banks (are able to) give, this is due to the fact that SBI is huge and it has surplus money, like LIC in insurance industry.
Yes, the interest of fixed deposit is calculated cumulatively, in general, the compound interest is calcualted on quarterly basis. However, many banks allow you to create a fixed deposit account online itself and they generally allow quaterly, half-yearly, yearly or even monthly - the shorter the better. However, the difference between quaterly and monthly compounding is very less, since the difference is only the interest on the interst of two months,which, in general is insignificant for interest rates less than 10 percent per annum.
Taxing on returns from Fixed Deposits
The interest paid on fixed deposit is part of your earnings - so, it is taxable. The tax is generally deducted from source, that means, banks deduct the tax from the interest of fixed depost and credit the remaining amount. However, if your total income from all the resources is less than or equal to the tax-free bracket, which is 2 lakhs as of 2013, you could submit a request called form-15 (form-15 A for senior citizens) to declare that you don't fall under any tax bracket including the interest from all fixed deposits. Banks do respect such requests and they do not deduct TDS. You should do this well in advance of the financial year, so bank do not deduct the interst from day-1. However, if bank had already deduct tax for the interest and you do not have any other sigificant income (ie., total < 2Lakhs), you could apply for the IT returns during tax-returns submission.
TDS is 10% as of 2013 september.