Does the effect of compounding outweigh higher rates?
Friday, February 17th, 2006
Categorized as: Savings Bonds and competitive investments
Interest on Savings Bonds is compounded twice a year whereas interest on savings accounts compounds daily. Will the impact of compounding more than offset the higher interest rate of Savings Bonds?
Tom’s response
While more frequent compounding is always better, the differences are minor. Financial advisors recommend using APY (annual percentage yield) to make equal comparisons between investments with different compounding periods.
Our Savings Bond Calculator will show you the lifetime yield of any Savings Bond in terms of APY.
However, it’s rare to see an APY for future Savings Bonds rates because most Savings Bonds have rates that adjust every six months. Since you can’t predict in advance what the interest rate will be for the second six-month rate period, you can’t calculate a forward-looking APY.
To give you some hard numbers, here’s the APY of a 5% interest rate with various compounding periods:
- 2 (semi-annual) 5.06%
- 4 (quarterly) 5.10%
- 12 (monthly) 5.12%
- 365 (daily) 5.13%
Note that the semi-annual compounding of Savings Bonds provides half the benefit of monthly compounding and that daily compounding is only a tiny bit better than monthly.
At lower interest rates, the difference is even less.
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Tom Adams
Tom, good explanation, but I think you typed “APR” in a couple places where you meant “APY”
EEEK! You’re right - I’m off to fix that now.
APR, annual percentage rate, is similar to APY in terms of the math, but it’s used when you borrow money rather than when you invest it.