An interesting question to be sure. Naturally, when investing funds into Certificates of Deposit (CDs), you want to know how much you are going to earn. If you are receiving your funds monthly, then the APR (Annual Percentage Rate) is what you are interested in. If you are allowing the interest to compound, the APY (Annual Percentage Yield) is what is important to you. And what about the rate for zero-coupon or discounted CDs? Read on. First, ask the bank or your broker what both rates are. Many banks will just post their APY. You might have seen some adds, such as "1-Year CD Rate @ 5.21% APY". And you're thinking, "WOW! Im going to earn $5,210." If I invest $100,000 and receive $434.17 a month. I can finally afford that Camry lease. Not so fast. If you are receiving the interest monthly, the monthly figure depends on the compounding of the bank. Lets assume the bank compounds monthly; that makes the APR about 5.09%. Your overall earnings will be $5,090 and monthly that is $424.17 a month (better stick with the Corolla). Now for the second scenario. You dont need the income monthly so you can let your interest compound. This means that on a fixed frequency, the interest is added to your principal and also earns interest. As a result, after each compound, more money is earning interest. Bank A is offering a 1-Year CD rate of 5.10% APR and Bank B is offering a rate of 5.15% APR. Certainly you are going with Bank B, right? Not so fast. Bank A compounds daily and Bank B compounds semi-annually. This means that for Bank A, the daily interest earned is added to the principal and thus the interest is earning interest much more often. With semi-annual compounding, the interest is only added to the principal twice (every six-months). So what is the difference? The APY for Bank A is 5.232% and for Bank B it is 5.216%. You earn more on a compounding basis ($5232 vs. $5216) with Bank A. In addition, some banks dont compound at all, especially when it comes to Jumbo CDs. If we use the same banks and Bank A compounds and Bank B doesnt, the difference is even more significant ($5232 vs. $5150). Finally, what is a zero-coupon or discounted CD? This is a CD where the principal is discounted and interest is paid at maturity. They are designed to mature at $100,000. For example, you invest $85,000 and when it matures, you receive $100,000; terms vary but for our example lets use 42-months. That sounds real nice doesnt it? After all, youll earn $15,000 (almost $5000 a year) and the CD was kept under the FDIC $100,000 insurance limits the whole time. But what is your rate? Make sure your broker or bank quotes you the Bond Equivalent Yield (BEY) and not the Average Rate of Return. The BEY takes into account the time-value of money, and gives you a rate that is based on the present value of your investment. The BEY calculation is very involved to do manually, but there is a simple calculation for the APY which will be a good check on what the broker is quoting you. The APY will be about 5 to 10 Basis Points (0.05% - 0.10%) higher than the BEY. For our example, if you were just quoted the Average Rate of Return, you would have been quoted 5.04%. Now for the APY calculation. The equation is (Future Value / Price) to the power of (365/# of Days until Maturity) - 1. This returns 4.747%. The BEY is about 4.69%. This means that an investment that cost you $85,000 and returns $100,000 in 42-months is worth a 4.69% today. Now you can compare apples to apples. Here is an example with numbers. We already know that the zero is going to pay you $15,000 after 42-months. But, if you take the same $85,000 and invest into a CD with an APR of 4.985% and APY of 5.10% (CD compounds monthly) for 42-months you will earn $16,166.22. More importantly, much of the time the difference in the APY is even greater for similar terms. The morale of the story; know what your needs are and compare rates appropriately. |
