Certificates of deposit are financial products that pay a guaranteed rate of interest. CDs are issued by banks, so they’re covered by FDIC insurance, just like your savings account. A traditional CD is considered a time deposit, because you purchase it for a specified period of time, such as one, five or 10 years. If you redeem a CD before the maturity date, you’ll typically pay an early withdrawal penalty based on the terms of the agreement.
CD interest rates vary by the length of time; generally, the longer the term, the higher the rate. Rates are typically higher for larger deposits, with jumbo CDs typically offering the highest rates. To make an informed decision about which type of CD is best for you, you have to consider its value. Here’s how to calculate how much money you’ll earn in interest when you invest in a CD account.
How to Calculate Interest on a CD
CDs earn compound interest, which makes them attractive to investors who are risk-averse. This means that CDs earn interest periodically — in some cases every day — and then that amount earns interest the next day.
Compared with simple interest, compound interest grows your money faster, but it also makes calculating your return a little more challenging. Here’s the formula to calculate the value of an investment that pays compound interest:
- A = P(1+r/n)(nt)
- A is the total that your CD will be worth at the end of the term, including the amount you put in.
- P is the principal, or the amount you deposited when you bought the CD.
- R is the rate, or annual interest rate, expressed as a decimal. If the interest rate is 1.25% APY, r is 0.0125.
- n is the number of times that interest in compounded every year. Most CDs pay interest that is compounded daily, so n = 365. Check with your bank to verify the interest is compounded daily.
- t is time, or the number of years until the maturity date.
For example, take a look at a deposit $10,000 in a five-year CD at 2.50% APR, compounded daily.
Here’s the calculation:
- A = 10,000 (1+0.025 / 365) ^ (365(5))
Using the correct order of operations, here’s the process:
- A = 10,000 (1+0.000068493150685)^(365(5))
- A = 10,000 (1.000068493150685)^(365(5))
- A = 10,000 (1.000068493150685)^1825
- A = 10,000 (1.133143602492102334771122378642)
- A = 11,331.44 (rounded)
The total at the end of five years would be $11,331.44. Because you deposited $10,000, you earned $1,331.44 in interest.
When you compare CD interest rates, make sure you’re comparing apples to apples. The calculation above is based on the annual percentage rate, or APR, of 2.5 percent. The annual percentage yield, or APY, is 2.531 percent. The APY will always be higher than the APR because of the compound interest.
What to Do When CD Rates Change
Investing in a CD means you’ll have your money tied up for a specified length of time at a fixed interest rate. Interest rates rise and fall, so you might find yourself a year or two into a CD that’s paying a much lower rate than you could get elsewhere. Here’s how that could happen and what to do about it.
When Interest Rates Rise
The Federal Reserve Bank has kept interest rates low for the last several years, but they’re now starting to inch up. A bump-rate CD will let you increase your rate, usually one time during the term of your CD, to the current rate.
Another option is to strategically ladder your CDs. When you ladder CDs, your money is invested in CDs with differing terms. For example, rather than buying a three-year CD for $15,000, you could buy three CDs with different maturity dates — such as $5,000 each in a one-year, a two-year and a three-year CD account.
When the Stock Market Outperforms
In 2016 the Standard & Poor’s/Case-Shiller home-price index, a mutual fund that mirrors the top 500 stocks, returned 9.84 percent. The same year, some of the best one-year CD rates were around 1.25 percent. The difference is that CD rates are guaranteed. As a point of reference, in 2008, the Standard & Poor’s 500 index lost 37 percent.
When Inflation or Taxes Increase
CD interest is taxable in the year you earn it, even if you don’t take the money out unless it’s in a qualified account like an IRA. It might make sense to use CDs for your tax-qualified investments like IRAs, and take more risk to get a better return in your non-tax-qualified accounts.
Now that you understand how to calculate the interest earned on a CD, you can compare the rates offered by different banks and choose the one that best fits your needs.
Read More: Here’s How Often CD Rates Change