One important concept to understand when you are buying a CD is the difference between what’s called the annual percentage yield (APY) and the annual percentage rate (APR). The Annual Percentage rate is, simply stated, the percentage rate of the interest your CD will earn in one compound period. However, the annual percentage yield can actually be different, based on how often your interest is calculated and compounded. If your CD pays interest annually, the APR and APY are the same. However, if your interest is compounded more than once a year, your total APY may actually be higher than your APR. The more frequently the interest on your account is compounded, the greater the yield will be.
Let’s say, for instance, that you purchase a one-year CD in the amount of $1,000, that pays 5% APR. However, the interest on that CD is compounded semi-annually. In this case, you would receive an interest payment in the amount of $25 (that’s one thousand dollars times five percent, times .5 years. You are still only receiving half a year’s interest – the same amount of interest you would have earned if your interest was calculated and paid out once a year. However, since you are receiving it midway through the year, that interest is compounded to your account, and begins earning interest of its own. By the end of the year, that interest has earned an extra 62 cents (twenty five dollars times five percent times .5 years = .0625). It may not sound like much, but over time, compounding can result in significant savings. And, in the case of this example, it bumps your APY a bit over your APR: your APR is 5%, whereas your APY would be 5.06%.
Almost every bank offers CDs, and as an investment tool, they can be very useful to the beginner investor as they are generally safe, not tied to indices like the stock market, and insured by the FDIC. But you should shop around to several institutions to see who has the best CD rates around, and don’t forget to ask how often the interest is compounded to make sure you have a high yield certificate of deposit. With interest compounded semi-annually or even monthly, your APY can be significantly different than your APR!