When you invest in a bank certificate of deposit or other fixed-income investment, you'll often get quoted an interest rate. However, in the fine print, you'll find what the compounding period is for the investment in question, which will typically be annual, semi-annual, monthly, or daily. If you have two investments with different interest rates and compounding periods, you have to look beyond the stated rate to figure out what the effective annual yield on the investment is. Whether you do the math yourself or use a calculator, knowing the effective annual yield gives you a number that you can compare to figure out which investment truly offers the best return.
A simple example
To understand how compounding periods work, consider two different investments. Both have stated interest rates of 6% and mature in one year, but one compounds annually while the other compounds semi-annually.
If you invest $1,000 in the annually compounded investment, the return is easy to figure. Take the 6% and multiply it by $1,000, and you'll get $60 in interest. At the end of the year, you'll have $1,060. Your effective yield was the $60 gain divided by the $1,000 investment, or 6%.
The semi-annually compounding investment works a little differently. At the end of six months, you take half the annual interest rate and multiply it by the principal amount. Half of 6% is 3%, 3% of $1,000 is $30, so at the end of six months, you'll have $1,030. Then, after six more months passes, you repeat the process, but using the new $1,030 balance. That yields an interest payment of $30.90, and that makes the total you get $1,060.90. When you divide $60.90 by $1,000, you get 6.09%.
You can see that the effective yield is slightly higher when you compound more frequently. That's because more frequent compounding gives the interest you earn a chance to generate more interest of its own. Granted, less than a tenth of a percentage point might not sound like much, but it can add up over time.
How much of a boost can you get from daily compounding?
To do more frequent compounding calculations, you'll want a calculator. The one below is very simple but lets you do multiple scenarios to do your own comparisons.
Editor's note: The following language is provided by CalcXML, which built the calculator below.
For instance, take the same example above but assume daily compounding. When you enter the numbers into the calculator, the answer works out to 6.18%. That's almost double the impact that compounding semi-annually had.
What this means is that if you have an investment that says it has an interest rate of 6% and compounds daily, it will generate the same yield as an investment with an interest rate of 6.18% that compounds annually. By running each comparable scenario through the calculator, you can get a list of effective annual yields and then just pick the highest.
Interest rates can be confusing, especially when compounding gets complicated. But by knowing how to come up with the effective annual yield, you can make it a lot easier to make comparisons and pick the best possible investment.
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