When comparing certificate of deposit (CD) options, you’ll likely notice two different numbers: the interest rate and the APY (Annual Percentage Yield). While these terms are closely related, they represent different ways of showing your potential earnings. Understanding both can help you choose the CD that truly fits your financial goals.
1. What’s the difference between the interest rate and the APY, and why do they matter?
The interest rate is the base rate your CD earns. The APY, or annual percentage yield, includes the effect of compounding, which is when your earnings generate their own earnings over time.
In simple terms:
- The interest rate shows your rate of return before compounding.
- The APY gives you a clearer picture of your total annual earnings.
Why this matters: If you're comparing CD rates, especially between different banks or terms, the APY is your best point of comparison. It shows what you could earn if you leave your interest untouched and let it grow.
2. How does compounding work?
Compounding helps your savings grow faster by paying interest not just on your original deposit, but also on the interest you’ve already earned.
Here's how it works:
- Interest is added to your CD at regular intervals.
- If you leave it alone, that interest becomes part of your balance.
- Future interest is calculated on the larger balance, not just your original deposit.
At Bank of Utah:
- For CDs with terms under one year, interest is compounded and paid at maturity.
- For CDs one year or longer, interest is compounded quarterly.
The more often interest is added and left to grow, the more powerful compounding becomes over time.
3. What does APY mean for a short-term CD?
If you open a short-term CD — like a 90-day or 6-month CD — that lists a 3.00% APY, it doesn’t mean you’ll earn 3.00% by the time the CD matures. APY stands for Annual Percentage Yield, and it’s meant to help you compare earnings across deposit products — no matter their term length — by showing what you could earn in a full year with compounding.
Since short-term CDs mature in less than a year, your earnings will be proportionally lower unless you continue to reinvest the funds.
Here’s how it works:
- If you withdraw your interest (or your principal) at maturity, compounding stops.
- If you roll your full balance into a new CD each time, you may continue to grow your savings, especially if rates hold steady or go up.
Tip: APY provides a standardized way to compare CDs of different terms and rates, but your actual earnings will depend on how long you keep your money in and whether you allow it to compound.
4. How is APY calculated?
If you like to see the math behind your earnings, APY uses a compounding formula to show how interest grows over time.
The APY formula is: A = P(1 + r/n)nt, where:
- A = Ending balance
- P = Initial deposit (principal)
- r = Annual interest rate as a decimal (for example, 3.00% is 0.03)
- n = Number of compounding periods per year (for example, quarterly would be four periods per year, so n=4)
- t = Time in years the money is invested (for a 1-year CD, t=1)
Example: You deposit $10,000 in a CD with a 3.00% APY, compounded quarterly, and leave it alone for one year.
A=10,000(1 + 0.03/4)(4x1)=10,304.52
That means you've earned $304.52 in interest, and that's the power of compounding built into your APY.
Putting It All Together
When choosing a CD, don’t just look at the interest rate. The APY tells the full story of how much you could really earn. If you’re planning to reinvest your interest and let your money grow over time, it pays to pay attention to the APY, and to understand how compounding frequency and reinvestment can boost your returns.
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