Question: I am thinking on saving money in a 3 year CD paying .28%. The bank brochure is telling me I’ll get .28% APR, but there’s another word in the brochure that talks about APY. What’s the difference?

Good question!

APR (Annual Percentage Rate) is what you see on the “face” of the account. Example: If I invest $1,000 in a 1 year CD that pays 5%, the 5% on the brochure at the bank means APR. So I’m led to think that I’ll make 5% ($50) for the year for a total of $1,050.

APY (Annual Percentage Yield) takes into account how often that interest rate is credited. Meaning does it credit a portion of that 5% monthly, semi-annually, or annually? If it’s annually, you’ll still get the 5% or $50.

If it’s semi-annually, you’ll get credited 2.5% every 6 months. This is a bit better since you can reinvest that interest payment ($25) for the remaining 6 months on the CD. Now, compound interest takes effect and you’re balance is at $1,025 in 6 months. That $1,025 now gets to partake in the remaining 2.5% that will evolve over the next 6 months. This adds up to be slightly more than your original $1,050 that you made for just the interest being credited for 1 year only. Being credited or compounded semi-annually leaves you with $1,050.63 at the end of 1 year.

If that $1,000 is credited (compounded) monthly you’re at $1,051.16. As you can see, the more compounding periods you have, the better. Thus the miracle of compound interest and the time value of money.

Works just the opposite against us when we borrow money.

Something to consider, although a CD will be 100% guaranteed by the FDIC, at .28% you’re not even keeping with inflation, in fact, you’re losing money. You may consider researching online banks that are FDIC insured that may offer a better yield.

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Great post Jim. Someone is making money here but it is not the deposit holder. Readers should know that online bank accounts give a higher yield but the tradeoff is usually no paper statements in the mail each month.

Thanks for the kind words, Steve (this is Sterling by the way). I had a good time writing this article and hopefully it can give readers some insight as to how compounding works on both sides of the coin.