Updated: Aug 10, 2020
Wait...What happens to your bank account rates on a leap year?
Seeing Rates with 2020 Vision
Being that 2020 is a leap year we've decided to expand on a particularly interesting reason why it's important to know what rate is being shown.
Leap Year = More Money...Maybe
On a bank's website you should be able to find a "Bank Deposit Agreement", "Account Agreement For Consumers", or something of the like. These documents disclose how interest can be calculated among a myriad of other minutia. What we're interested in seeing is how money in an account is compounded. To see how it differs in leap years, one way is to look to see if it's calculated by a rate divided always by 365. If it is always 365 days then you're in luck and here's why: Let's saying you're bank is offering you an interest rate of 365%. That means you effective earn 1% a day for 365 days (without accounting for compounding). Well in a leap year that would mean you get 1% for 366 days. Which increases your APY (which accounts for compounding). As it turns out, even an interest rate that accrues on a daily basis will see an increase in the APY, just a much less significant one.
A real life example of this is Ally Bank. Currently at "1.60% APY" their high-yield savings account "is calculated by dividing the interest rate by three hundred sixty-five (365) days, even in leap years." Meaning that their actual APY is 1.6001%, whereas a daily compounding account would be 1.5990% APY.
With $10,000 over 4 years this amasses to a WHOPPING $0.45 difference... so this might not be the most exhilarating raise ever but it goes to show that rates might not be as you'd expect. So why the big deal?
The Question We All Ask
We've all started a new job and had to once again allocate funds for retirement. The process where we are handed a list of portfolios to chose from and know nothing about what to really look for. How many of us have gone to the portfolio percentage return over X time and said, "This is easy, I'll just pick the biggest return!" and been confused why we all don't just do that? Risk tolerance maybe? Nope, it's in the definitions. We only wish it were that easy.
Rates of Return
An example of why you should make the distinction is if the portfolios are shown as average rates of return. This usually is different than what people we talk to expect when they think of returns over time. Here's an example of what we're talking about.
These are how two portfolios preformed over 3 years:
Portfolio 1: Up 10%, Down 20%, Up 40%
Average Return (10-20+40)/3=10%
Portfolio 2: Up 10%, Up 10%, Up 10%
Average Return (10+10+10)/3 = 10%
Both of these portfolios had an average rate of return of 10%. However, if you had $100 in each you'd be $9.90 richer with the second option. The second portfolio really had an annualized rate of return of 10% but the first portfolio only yielded 7.20% annualized.
An Annualized Rate of Return is the equivalent year to year return an investor receives.
I bet you wouldn't be surprised to hear that some companies would rather offer a 10% average rate of return than a 7.20% annualized rate of return. Especially if it were to stay competitive with the other portfolio.
The Most Important Takeaway
Understanding your actual return is so crucial to your decisions and will help you better plan for your future. In our portfolio example, if people put their retirement in the hands of the first portfolio expecting to get 10% every year they'd be disappointed with their only 7.20% annualized gain.
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