How Interest Is Figured
Comparing interest rates for certificates of deposit? You will see the terms APY (Annual Percentage Yield) and APR (Annual Percentage Rate) in the brochure. What does each mean and how are they different?
APR is the account’s headline number. For example, if you invest $1,000 in a one-year CD that pays 5%, that means the CD’s APR is 5%. So it seems as if the account makes 5% ($50) for the year for a total of $1,050. But this might not actually be the case.
APY takes into account how often that interest rate is credited. Does it credit a portion of that 5% monthly, semi-annually or annually? If it’s annually, you still get the 5% or $50.
If it’s semi-annually, you get credited 2.5% every six months. This is a bit better since you can reinvest that interest payment ($25) for the remaining six months on the CD. Now, compound interest takes effect and your balance is at $1,025 after six months.
That $1,025 now gets to partake in the remaining 2.5% that evolves over the next 6 months. This adds up to slightly more than the $1,050 balance that annual compounding brings you. Being credited or compounded semi-annually leaves you with $1,050.63 at the end of one year.
If that $1,000 is credited (compounded) monthly you’re at $1,051.16 when it matures. As you can see, the more compounding periods you have, the better. This is the miracle of compound interest and the time value of money.
On the other hand, compounding interest works against us when we borrow money. Before you take out a home or auto loan or credit card, note how often the interest rate is calculated as well as the APR rate.
Generally, certificates of deposit are very safe, 100% guaranteed by the Federal Deposit Insurance Corp. They do give you some yield, but unlike the example above, they aren’t known for generosity.
According to Bankrate the best offer for a one-year CD is 1.05% APY with a minimum investment of $5,000. At this rate, you do not even keep with inflation. In fact, you lose money. The latest government inflation figures (which some accuse of low-balling) show that consumer prices rose 1.7% over the course of 2012. And this is below average.
Of course, if you don’t need the funds any time soon (most CDs charge high fees for early withdrawal), putting your money into a CD is better than letting it sit in your checking account to be slowly eroded by inflation.
Look into CD and savings offers from online banks. As long as they are FDIC-insured, you have nothing to worry about. Without the expense of brick-and-mortar banks, online banks usually offer a better yield.
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Sterling Raskie, MSFS, CFP, is an independent, fee-only financial planner at Blankenship Financial Planning in New Berlin, IL. He is an adjunct professor teaching courses in math, finance, insurance and investments. His blog is Getting Your Financial Ducks in a Row, where he writes regularly about investments, retirement savings and financial planning.
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