What Is the Difference Between APY and Interest Rate on a CD?
Understand the key differences between APY and interest rate on a CD, including how they are calculated and what they mean for your savings growth.
Choosing a certificate of deposit (CD) requires understanding the difference between interest rate and annual percentage yield (APY). While both relate to earnings on your deposit, they are not interchangeable and can significantly impact how much you actually earn.
A clear distinction between these figures ensures accurate comparisons across different CDs.
Interest Rate Details
The interest rate on a CD represents the percentage the bank agrees to pay on your deposit over a specified period. This rate is set at the time of purchase and remains fixed unless the CD is structured as a variable-rate product. Banks determine these rates based on factors such as Federal Reserve policy, market conditions, and CD term length, with longer-term CDs typically offering higher rates.
While banks advertise interest rates to attract depositors, these figures alone do not fully capture earnings potential. The stated rate reflects only simple interest before factoring in compounding. Some CDs pay interest monthly, quarterly, or annually, while others credit interest only at maturity. The frequency of these payments affects how much money is available for reinvestment or withdrawal before the term ends.
APY Details
APY accounts for compounding, providing a more accurate measure of total interest earned over a year. Unlike the nominal interest rate, APY reflects how frequently interest is added to the balance, leading to higher overall earnings. This makes APY a more useful figure when comparing CDs from different banks.
Financial institutions calculate APY using the formula:
APY = (1 + r/n)ⁿ – 1
where r is the annual interest rate and n is the number of compounding periods per year. More frequent compounding results in a higher APY even if the nominal rate remains the same. For example, a CD with a 5% interest rate compounded monthly will yield a slightly higher APY than one compounded annually, as reinvested interest generates additional earnings.
Differences in Calculation
The way interest rate and APY are calculated affects total earnings. While the interest rate provides a basic percentage of return, APY accounts for compounding, which can significantly impact growth.
Frequency of Compounding
Compounding refers to how often interest is added to the principal balance. Banks may compound interest daily, monthly, quarterly, or annually, with more frequent compounding leading to higher returns.
For example, a CD with a 4% annual interest rate compounded quarterly applies one-fourth of the 4% rate (or 1%) every three months, including previously earned interest. Over a year, this results in an APY slightly higher than 4%.
Consider a $10,000 CD with a 4% nominal interest rate:
– Annual compounding: $10,000 × (1 + 0.04/1)¹ = $10,400 (APY = 4.00%)
– Quarterly compounding: $10,000 × (1 + 0.04/4)⁴ = $10,407.04 (APY ≈ 4.07%)
– Monthly compounding: $10,000 × (1 + 0.04/12)¹² = $10,408.16 (APY ≈ 4.08%)
Even with the same nominal rate, APY increases as compounding becomes more frequent, making it a clearer measure of actual earnings.
Relationship to Nominal Rate
The nominal interest rate is the base percentage applied to the initial deposit, but it does not reflect compounding. APY always equals or exceeds the nominal rate, depending on how often interest is compounded. If a CD compounds interest only once per year, the APY and nominal rate will be identical. More frequent compounding results in a higher APY.
For example, a CD with a 3.5% nominal rate compounded semiannually will have an APY greater than 3.5% because interest is applied twice a year. This distinction is crucial when comparing CDs, as one institution may advertise a higher nominal rate while another offers a better APY due to more frequent compounding.
Regulations such as the Truth in Savings Act (12 CFR Part 1030) require financial institutions to disclose APY alongside the nominal rate to prevent misleading advertising, ensuring consumers can make informed decisions.
Effective Annual Return
The effective annual return (EAR) expresses the impact of compounding, similar to APY. While APY is used for deposit accounts, EAR is more common in investments and loans. Both represent the true annualized return, but APY is specific to consumer banking products.
The EAR formula is:
EAR = (1 + r/n)ⁿ – 1
which is identical to the APY formula. For CDs, APY and EAR are effectively the same.
For example, if a CD offers a 5% nominal rate with monthly compounding, the EAR (or APY) would be:
(1 + 0.05/12)¹² – 1 = 5.12%
Even though the stated rate is 5%, the actual return over a year is 5.12% due to compounding. Understanding this distinction helps depositors assess the true earning potential of a CD rather than relying solely on the nominal rate.
Common Misconceptions
Many assume a higher advertised rate always leads to greater earnings, but this can be misleading. Different financial institutions apply varying methods for crediting interest. Some CDs allow periodic withdrawals of earned interest without penalty, while others require all interest to remain until maturity, affecting liquidity and reinvestment options.
Another misunderstanding involves callable CDs, which allow the issuing bank to terminate the CD before maturity. These CDs often offer attractive rates, but if interest rates decline, the bank may “call” the CD early, forcing reinvestment at lower prevailing rates. This risk is not present in standard fixed-term CDs, making it important to review terms carefully before committing funds.