CD rates and compound interest

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Two ubiquitous banking acronyms pop up everywhere, but it can be difficult to keep them straight: APR and APY.

APR stands for “annual percentage rate” and is applied to loans. Though we often refer to CD rates in this blog, we’re really talking about the yield. The annual percentage yield, or APY, should be what savers find when they go into a financial institution to buy a CD.

Stating returns in terms of APY makes it easier to compare accounts. It’s also a law. The Truth in Savings Act requires that banks and financial institutions display the annual percentage yield on certificates of deposit.

The APY covers the interest rate paid on the account as well as the effect of compounding over a year. The nominal rate may be 1 percent, but the interest compounds with the frequency of interest payments. More interest payments in a year equals a higher yield.

The effect of compounding periods on APY
  Annual Semiannual Quarterly Monthly Weekly Daily Continuous
Annual percentage yield 5% 5% 5% 5% 5% 5% 5%
Effective annual rate 5% 5.0625% 5.0945% 5.1162% 5.1246% 5.1267% 5.1271%

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