Understanding Yields on CDs

CDs have rates and they have yields. Knowing the difference between the two could mean a few more dollars in your pocket.

Robert Fulghum wrote a best-selling book called All I Really Need To Know I Learned In Kindergarten. Unfortunately, unless little Robert's teacher was a moonlighting banker, he probably didn't learn much about choosing or managing his CD investments.

Understanding your options

Certificate of deposit (CD) yields and rates are "need to know" topics for anyone interested in federally insured investments. CDs are fixed-rate time deposits, insured by either the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union administration (NCUA). When you buy a CD, you agree to leave a fixed amount of money on deposit with the issuer for a specified time period. In return, the issuer promises to pay you a set interest rate on your deposit.

The most confusing part of CD investing is this: Banks and credit unions quote two separate rates in CD advertisements, a stated rate, and an annual percentage yield (APY). Most of the time, these two rates differ by only 10- or 12-basis points, i.e., the difference between 5.0 percent and 5.10 or 5.12 percent.

Once you spot these two rates, you're likely to wonder why they come in twos, and which one is the real one. You're also probably hoping the APY is the one that counts, because that one's always higher than the stated rate.

Stated CD rates, APY, and compounding

The difference between the stated rate and the APY is related to the phenomenon of compounding interest. To demonstrate how this works, let's consider a one-year, 5-percent CD that's compounded quarterly. If you deposit $5,000 into this CD, you can expect four interest payments during the course of a year. After the first interest payment of $62.50, your interest-earning balance is $5,062.50. After the second interest payment of $63.28, your interest-earning balance is $5,125.78. In other words, compounding allows you to earn interest on your principal plus any interest earned in prior periods. Your balance in this account at year-end would be $5,254.73.

On the other hand, if the 5-percent interest on that $5,000 deposit wasn't compounded, your year-end balance would be $5,250.

Now, compare the return of $254.73 in the compounded account to the return of $250 in the non-compounded account. If you divide these two figures by the principal of $5,000, you get 5.09 percent and 5.00 percent, respectively. Both accounts have a stated rate of 5 percent, but the compounded account has a higher APY of 5.09 percent.

Because the APY includes the effect of compounding, it provides a better indication of the return you can expect on your CD. The APY also allows you to compare the performance of two CDs that have different compounding methods.

To put this life lesson into the simplest terms: You'll come out ahead if you select a CD based on the APY and not the stated rate.