New York -- It's rough out there in the interest-rate jungle. Savers and investors are making decisions based on tiny differences in yields. But those differences may not be worth the sweat. Here's an interest-rate primer, to help you judge.
* Banks. Bank certificates of deposit disclose two things: Simple interest, which is the annual rate applied to your money; and effective yield, which shows what you earn when your interest compounds. A one-year CD paying 4.67 percent compounded daily produces an annual effective yield of 4.78 percent.
That same interest rate compounded monthly might yield 4.77 percent, according to Irwin Kellner, chief economist of the Chemical Banking Corp. The difference is so small that monthly vs. daily compounding shouldn't sway your choice of banks.
Interest-paying checking accounts and bank money-market accounts take the rate guaranteed for, say, the next seven days and annualize it. So the advertised rate means, "this is what we would pay for a year if next week's rate really lasted all year and if you reinvested all the interest you earned." In real life, however, the bank changes its rates periodically.
Today, bank money-market accounts pay roughly the same as money-market mutual funds. If the bank gives its savings depositors breaks on fees and loan rates, the bank account is the better buy.
Warning: Of two banks advertising the same yield, one may be paying less in dollars and cents. That's because the cheapo bank might not pay interest on your full deposit every day. Always ask about this before opening an account.
* Bonds. Bonds confuse you by posting three rates. The "coupon rate" gives the interest payment as a percent of the bond's face value. A $1,000 bond paying $90 a year has a coupon rate of 9 percent. The "current yield" shows what you're earning on the amount you invested. If, due to market conditions, you paid $1,020 for that $1,000 bond, its annual payment of $90 amounts to an 8.8 percent current return on your investment.
When your bond matures, however, or is paid off before maturity, you will normally receive only its $1,000 face value. If you paid $1,020, you'll have a $20 loss. Your "total return" subtracts that loss from the interest you earned. In this example, your total return after 10 years might be 8.6 percent. (Note that if the bond cost you $980 you'd have a $20 gain. That would raise your total return.)
Stockbrokers sometimes highlight a fat current yield without disclosing that your total return will be less. Ask for the total return, calculated in two ways: the yield to maturity and the yield to the first day the bond can be called for redemption.
Last point: A bond's quoted return assumes that you will reinvest all the interest income at the original current yield. If you spend the interest, or reinvest it at a lower rate, your return will be less.
* Treasury Bills. With bills, you pay less than face value and earn your interest by redeeming for face value at maturity. Always check a Treasury's "coupon equivalent yield" (listed as "ask yield" in The Wall Street Journal). That gives you a reasonably fair comparison with what you might earn from competing bonds and banks.
* Bond and Money-Market Mutual Funds. When a money-market mutual fund advertises 3.5 percent,
it means that -- over the past seven days -- the fund paid an average amount that would yield 3.5 percent simple interest, if that rate of payment lasted all year. Your real return, however, will depend on whether market rates rise or fall. A fund that's a half-point ahead today may be a half-point behind next week. So go for convenience. Use the one linked to a mutual-fund family whose other funds you might want to buy.
The quoted yields on bond mutual funds are based on average yields over the past 30 days. But share prices change as the market fluctuates. To see how well you might do, ask for the fund's past one-, five-and 10-year total returns.
The interest rates on bank deposits and bonds aren't computed in exactly the same way. Bond funds and many bonds use a 360-day year while banks might use 365 or 366. Even if a bank and a fund are both paying exactly the same interest in dollars and cents, the different calculation methods may make the fund appear to be paying 0.05 to 0.15 percentage points more, according to the Federal Reserve. That's a good reason not to make an investment decision based on small differences in stated yield. They may not mean anything at all.