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The difference between rate and yield is determined by how frequently interest is paid, and how it is paid.
Rate is the nominal, or stated, interest rate on the investment. If you have a CD with a 5-percent nominal rate or APR, interest is calculated by multiplying the amount invested by 5 percent and by the fraction of a year the money is invested.
Let's say interest is paid annually. A $10,000 investment will earn $500 in interest. ($10,000 x 5 percent x one year.) When an investment pays interest annually, its rate and its yield are the same.
But when interest is paid more frequently, the yield goes up. That's because the interest payment is credited to the CD more quickly and it starts earning interest along with the invested principal.
If the 5 percent CD paid interest twice a year, the six-month interest payment would be $250, ($10,000 x 5 percent x .5 years.) Then the $250 payment starts earning interest too and earns $6.25 in interest during the next six months, ($250 x 5 percent x .5 years.) That extra interest is added on and starts earning more interest. That's what compounding interest is all about.
The first CD, where interest was paid just once during the year, earned $500 in interest after a year, but the second CD, where interest was paid twice during the year, earned $506.25 in interest. The rate and yield on the first CD is 5 percent. The rate on the second CD is 5 percent, but its yield is 5.06 percent.
To get that yield you must reinvest the interest.
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