These days, a popular investment vehicle seems to be what the financial industry terms increasing (”Escalating or Accelerated”) rate Guaranteed Investment Certificates (GIC).

The idea behind these GICs is that the longer you hold the GIC, the higher the interest rate earned in those later years. Typically, you will earn less money at the beginning than you would for a normal, fixed rate GIC. However, the last year tends to be a whopping large amount!

So, how do you compare these increasing rate GICs with the regular, fixed interest rate GICs? You would compare their effective yields.

For example, a typical 5-year GIC with a fixed rate of 3.125% implies that each and every year, you will earn 3.125% on the amount invested. In this case, your effective yield is 3.125%. That was easy.

How about an increasing rate GIC? As an example, let’s assume an increasing rate GIC that pays 2% the first year, 2.5% the second year, 2.6% the third year, 3% the fourth year, and 8% the fifth year. Comparing this to the above fixed rate GIC, you can see that in 4 of the 5 years, you are earning less interest than in the fixed rate GIC. However, in the last year of the increasing rate GIC, you earn a whopping 8%!

Let’s calculate the effective yield of the increasing rate GIC.

The formula:

Effective Yield = ((1 + i1) x (1 + i2) x … x (1 + in))^(1/n) x 100%

where

i# = the interest rate for year #

n = total number of years

In our example, we would have:

i1 = .02
i2 = .025
i3 = .026
i4 = .03
i5 = .08
n = 5

Effective Yield = ((1+.02) x (1+.025) x (1+.026) x (1+.03) x (1+.08))^(1/5) x 100%

Effective Yield = 3.5968%

In this case, the effective yield is 3.5968%.

Just to prove it to ourselves that this is in fact the effective yield, let’s show how this particular GIC would grow. Let’s assume we invest $1,000 at the beginning of year 1. We will let the interest compound yearly and the interest earned is reinvested.

End of Using Actual Rate Using Effective Yield Rate

Year 1 $1,020.00 $1,035.97

Year 2 $1,045.50 $1,073.23

Year 3 $1,072.68 $1,111,83

Year 4 $1,104.86 $1,151.82

Year 5 $1,193.25 $1,193.25

So, as you can see, at the end of year 5, you would have the same amount of money. All the effective yield rate does is give you the rate that would be used each year if the rate was fixed. In this example, you would be better off taking this increasing rate GIC over the fixed rate 5-year GIC at 3.125%.