How Are CDs Compounded and Why Does It Matter?

Certificates of Deposit (CDs) serve as a popular savings tool, offering a secure way to grow funds over a fixed period. These accounts typically provide a guaranteed interest rate in exchange for keeping money deposited for a set term. Understanding how interest is calculated on a CD, particularly through compounding, helps savers maximize their earnings.

What Compounding Interest Means

Compounding interest involves earning interest not only on the initial principal amount but also on the accumulated interest from previous periods. This concept allows money to grow at an accelerating rate because the base on which interest is calculated continuously increases. For example, if $100 earns 5% interest in the first year, it becomes $105; in the second year, the 5% interest is calculated on $105, leading to greater earnings than if only the original $100 earned interest.

In contrast, simple interest is calculated solely on the original principal amount, meaning the interest earned remains the same each period. With simple interest, if a $1,000 investment earns 5% annually, it would generate $50 each year, regardless of how long the money stays in the account. Compounding interest, however, ensures that the total amount grows more significantly over time. The difference in returns between simple and compound interest becomes more substantial over longer periods.

Compounding in Certificates of Deposit

Most Certificates of Deposit offer compounded interest. This means interest earned is periodically added to the principal balance, which then earns interest in subsequent periods, allowing the investment to grow faster.

Interest on CDs is calculated and compounded at regular intervals, such as daily, monthly, or quarterly. When interest is compounded monthly, for instance, the annual interest rate is divided by twelve, and the resulting monthly interest is applied to the principal. This action increases the account balance, and the next month’s interest is then calculated on this larger sum. Similarly, daily compounding calculates interest up to 365 times a year.

Key Considerations for CD Compounding

The frequency of compounding impacts the total return on a CD. More frequent compounding, such as daily versus annual, generally leads to slightly higher earnings because interest is added to the principal more often, allowing it to earn interest sooner. While the difference may seem small in the short term, it can become more noticeable over the full duration of the CD. Financial institutions will specify the compounding frequency in the CD’s terms.

The length of the CD term also plays a role in how effectively compounding can work. Longer CD terms provide more time for the interest to compound, allowing the investment to grow more substantially. For example, a five-year CD will generally yield a higher return from compounding than a one-year CD with the same interest rate. This is because the “interest on interest” effect has more periods to accumulate.

Distinguishing between the Annual Percentage Rate (APR) and the Annual Percentage Yield (APY) is important when evaluating CDs. The APR represents the nominal interest rate, while the APY reflects the true annual return, accounting for the effect of compounding interest. For compounded CDs, APY is the more relevant figure to consider, as it provides a clearer picture of actual earnings. Banks and credit unions commonly advertise the APY for their deposit products, as it includes compounding frequency.