Different saving options come with different benefits, such as dividends or interest, and different drawbacks, such as fees or restrictions on when you can take out your money and how much. When shopping around for the best place to park your money, understanding what dividends are and how to compare dividend rates is an important skill, as comparing dividend rates is not always as straightforward as it sounds.
Dividends and Interest
The first thing to understand is the difference between dividends and interest. While they sound like they should mean the same thing, and are even often used interchangeably when discussing different saving options, they actually have different meanings.
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Interest is something you earn by lending out your money. It is basically the recipient paying you the opportunity cost of not having that money available for a time. In the case of a certificate of deposit, or CD, a bank, company or government is borrowing money from you for a set period of time and is paying you interest for that privilege. During this time, you don't have access to the funds. Interests rates are defined by a contract and are therefore guaranteed.
More About Dividend Bank Accounts
Dividends, on the other hand, represent a portion of the profits owed to you when you are part-owner of a company. This is why, when you open a savings account with a credit union, you earn dividends, not interest. You become a part-owner of the credit union (generally a very small part) and are entitled to a share of its profits.
National credit unions generally have better dividend rates than the savings rates at online banks, and online banks tend to have better rates than brick-and-mortar banks. Local credit unions may have even better rates but stricter requirements for joining.
While dividends and interest rates function the same in calculations, it's important to understand that they're different concepts that entail different privileges and obligations on both parties. The Federal Deposit Insurance Corporation controls national rates and rate caps.
Calculating Dividends and Different Saving Options
Comparing dividend or interest rates is not as straightforward as just looking at the quoted dividend or interest rate and seeing which one is higher. How often it's compounded is just as important. This means how often the dividend is calculated and then added back to itself. Compounding schedules are usually daily, monthly or quarterly.
To understand compounding, imagine you have $20,000 in each of two accounts with dividend rates of 1 percent, one compounding daily and the other annually. You want to know how much money you'll have in each account at the end of one year. These accounts have different periodic rates, which are the rates applied to the relevant unit of time.
The annually compounding account's periodic rate is the dividend rate (1 percent or 0.01) divided by the number of compounding periods (years) in a year: 1. This comes out to the same number: 0.01. Apply the periodic rate to the balance over and over for the number of periods in the year, which is again just one time. This gets you $20,200 at the end of the year, for $200 earned in dividends.
Rates and APY
However, the number of periods for the daily account is 365, as the compounding period is a day and there are 365 days in a standard year. Therefore, the periodic rate of the daily account is 0.01 divided by 365, or 0.000027397. This looks much smaller, but the power is in applying this rate over and over, all year long, 365 times.
The first day you have the account open, this rate is applied to the $20,000 balance to get $20,000.0547945. That's just a five-cent gain, but then the periodic rate is applied to that again the next day to get $20,001.095905. That number climbs all year long until, at the end of the year, you will have $20,201. In this simple math example, you've earned another dollar just by choosing a different compounding rate.
For this reason, comparing dividend rates is not enough. You need to compare the annual percentage yield, or APY, which takes into account the compounding schedule. This is the "effective" dividend rate if you put a given amount in the savings account or other product and left it alone for a year. Most savings options will advertise their APY or include it in their disclosures. If they don't, you can calculate it using a dividend calculator for savings accounts or a compound interest calculator such as the one at Investor.gov.
Other Benefits and Restrictions
In addition to comparing the APY, look for other benefits, drawbacks and restrictions. Keep in mind how much flexibility you need. For example, some products, such as CDs, will penalize you significantly if you withdraw your money before the agreed-upon date.
Other factors could be ATM fees, transfer fees and other costs. The Mission Fed Credit Union provides examples of other costs to look for, like maintenance fees, convenience fees, service fees, excessive activity fees and more.