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CD Rate and APY: What's the Difference?

By Features Bankrate.com

Dear Dr. Don,
I was told by one bank that a certificate of deposit's interest yield is when money stays in the account to maturity and the rate is if you were to receive a monthly check for the interest. 

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I never took an interest check, but the final payout at maturity has always been based on the rate percentage and not the yield percentage offered. (I only invest in one-year and two-year CDs.) Even the Bankrate CD calculator only figures in the interest rate and not the yield for final payout. Please help.
-- Ernest Interest

Dear Ernest,

I was always taught that you earn a yield but pay a rate, but to answer your question, the distinction is between the CD's nominal, or stated, yield and its annual percentage yield, or APY. The stated yield is the yield used to calculate the interest payment, and the APY is the effective yield after considering the effect of the interest payments compounding.

The Truth in Savings Act, or TISA, requires financial institutions to post the APY when advertising yields so depositors can compare CDs on an apples-to-apples basis. The APY factors in how frequently interest compounds. Two CDs with the same nominal rate and maturity will have different APYs if they have different interest compounding periods. All else being equal, the CD with more frequent compounding will have a higher APY.

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If the CD pays interest to the depositor by check instead of adding it to the account balance, then the interest doesn't compound. Without the miracle of compound interest, the deposit doesn't earn the APY and instead earns the nominal rate. However, if the interest payment is added to the account balance, then it starts to earn interest along with the initial deposit.

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In today's low interest-rate environment, the difference between the APY and the nominal rate is only a few hundredths of a percentage point. Using Bankrate's tool for comparing CD rates, in mid-July I found a CD that pays a stated rate of 1.49% compounded daily. Its APY, which is also reported on Bankrate, is 1.5%.

Bankrate has a host of savings calculators on its site, though not all of them provide an annual percentage yield. The one that's right for you to calculate an APY based on a nominal rate is its CD calculator. I used the rate and term of the above CD, and the calculator provided the APY. It matched the APY provided by Bankrate's CD rates tool.

In your specific situation, I'm thinking there was some confusion between you and the bank about the nominal yield and the APY. If you kept the money invested earning interest, then your yield is the APY. The depositor that has the interest paid out of the account every month earns the nominal yield on the deposit.

I'm not quite sure why you haven't been able to use the APY to calculate the return on your investment if you reinvested the interest payments, but the bank had it right.

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