Understanding Bank CD Rates

Before choosing any investment, including bank CDs, it is important to understand how the investment works and what the expected rate of return will be.  The primary benefit of investing in any security type is the return on investment or income that will be received from that investment over time.

Certificates of deposit, also known as CDs, are special types of deposit accounts with a bank or thrift institution that typically offers a higher rate of interest than regular savings accounts.  CDs are typically fixed term and fixed rate.  The term or length of the CD is going to be fixed, usually running from three months, six months, or one to five years.  Since CDs have early withdrawal penalties, most CDS are held for the full term.   Other investments may or may not have a fixed term and even on investments such as bonds that do have fixed terms, an active secondary market and a no early withdrawal or sale penalty, means these investments can be and are often sold prior to maturity.  Most CDs are also fixed rate CDs, however some CDs are variable rate, some bank CDs are tied to an index, some bank CDs have call features and some have other esoteric options like step ups, bump ups and liquid CDs.  These bank CDs are the minority of CDs currently being offered in the banking industry with fixed rate CDs being the overwhelming majority.

Before an investor purchases a bank CD, they should make sure they fully understand all of its terms and carefully read the disclosure statement.  When a buyer of a bank CD initiates action with the bank offering the CD, the investor should receive a disclosure document that describes the interest rate on the CD and whether the rate is fixed or variable.  Be sure to understand how often the bank pays the interest on the CD and how the CD accountholder can receive the interest paid.  CD interest is often paid monthly or semi-annually and can be paid by check, added to the bank CD account or deposited in a separate bank account.  Bear in mind that any earned interest that is taken from the CD won’t be available to help the investment compound the earned interest.

Compounding is interest earned on the CD’s accumulated interest.  The more frequently the interest is credited to the account, the sooner the accumulated interest income will generate additional interest.  The initial interest rate displayed for the CD is the actual rate of interest without compounding.  This is simply the stated interest rate an accountholder will earn in one year.   The published interest rate is the APY or annual percentage yield.  In fact, banks are required by law to state the annual percentage yield.  This is the effective annual interest rate earned for the CD taken compounding into consideration.  APY is the total amount of interest you earn in one year taking into account the compound interest that will accumulate.

A bank CD’s APY depends on the frequency of compounding and the interest rate.  The more frequently the interest earned on the CD is compounded, the faster the interest rate can be applied to a larger balance.  This is because the APY is measuring the interest paid on the principal amount of the investment plus the interest on the accrued interest earned.  In view of the fact that the APY measures the interest rate annually while measuring how often the interest accrues it can be used to compare CD’s of different interest rates, different terms and compounding frequencies.

Many bank CDs allow the CD purchaser to have the interest earned on the CD periodically mailed as a check or transferred into a checking or savings account.  This reduces total yield because there is no compounding on that interest.  Compounding, however has no relation to how often the interest is paid out.  It is how often the interest is credited to the account.  If, for instance, a bank CD has interest compounded daily, this does not mean that interest checks are written every day the amount is merely an electronic entry and credited to the bank CD account.

Because the APY includes the effect of compounding, it provides an enhanced measure of the return an accountholder can expect with a bank CD.  The APY, is a standardized measure and is designed to make it easier for consumers to compare CD rates.  For investors considering a bank CD purchase it is better to select a CD based on the APY and not the stated CD rate.  A CD with a higher APY is paying you interest at a better rate, no matter what the length of the term is.

Tags: bank CD rates, CD rates, compound interest

This entry was posted on Wednesday, January 28th, 2009 at 10:39 am and is filed under Money Rates. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.