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The difference between rate and yield is determined
by how frequently interest is paid and how it is paid.
Rate is the nominal, or stated, interest rate on the
investment. If you have a CD with a 5-percent nominal rate or APR,
interest is calculated by multiplying the amount invested by 5 percent
and by the fraction of a year the money is invested.
Let's say interest is paid annually. A $10,000 investment will
earn $500 in interest. ($10,000 x 5 percent x one year.) When an
investment pays interest annually, its rate and its yield are the
same.
But when interest is paid more frequently, the yield
goes up. That's because the interest payment is credited to the
CD more quickly and it starts earning interest along with the invested
principal.
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Annual versus compounding interest |
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interest |
Compound
interest |
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If the 5 percent CD paid interest twice a year, the
six-month interest payment would be $250, ($10,000 x 5 percent x
0.5 years.) Then the $250 payment starts earning interest, too,
and earns $6.25 in interest during the next six months, ($250 x
5 percent x 0.5 years.) That extra interest is added on and starts
earning more interest. That's what compounding interest is all about.
The first CD, where interest was paid just once during the year,
earned $500 in interest after a year, but the second CD, where interest
was paid twice during the year, earned $506.25 in interest. The
rate and yield on the first CD is 5 percent. The rate on the second
CD is 5 percent, but its yield is 5.06 percent.
To get that yield you must reinvest the interest.
To find the best rates and yields on CDs, checking
and money market accounts, check out Bankrate.com's "Savings
& CDs" page.
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Chapter
1: Building liquid savings
