How Are Certificate of Deposit (CD) Rates Compounded?

A Certificate of Deposit (CD) serves as a savings tool where you deposit money for a set period, known as the term, in exchange for a fixed interest rate. This low-risk investment offers predictable returns. The core of how these returns grow lies in how interest rates are compounded, which significantly influences total earnings over the CD’s term.

Understanding Compound Interest

Compound interest is calculated not only on the initial principal but also on accumulated interest from previous periods. This differs from simple interest, which is calculated solely on the original principal. With simple interest, if you deposit $1,000 at a 5% annual rate, you would earn $50 each year, and this amount would not change.

The power of compound interest stems from its “interest on interest” effect, leading to accelerated growth over time. For instance, if you invest $1,000 at a 5% annual compound interest rate, you earn $50 the first year. In the second year, the 5% interest is calculated on $1,050, meaning you earn $52.50, and this growth continues. This allows money to expand more rapidly than with simple interest, as savings grow at an increasing rate.

Compounding Frequencies for CDs

For Certificates of Deposit, interest is commonly compounded at various frequencies, impacting overall earnings. Common compounding schedules include daily, monthly, quarterly, semi-annually, and annually. The more frequently interest is compounded, the more often the earned interest is added back to the principal balance.

When interest is added to the principal more frequently, newly added interest earns interest sooner. For example, a CD compounding daily adds interest to the principal 365 times a year, while a monthly compounding CD does so 12 times. Even with the same stated interest rate and term, a CD that compounds daily will yield slightly higher total earnings than one that compounds annually. This is because earlier compounding creates more opportunities to generate additional returns over the CD’s term.

The Role of Annual Percentage Yield (APY)

While a Certificate of Deposit has a stated interest rate, the Annual Percentage Yield (APY) provides a more comprehensive measure of your actual return. APY is the true rate of return because it accounts for the effect of compounding over a full year. APY includes the basic interest rate and the impact of compounding frequency.

APY is a crucial tool for comparing different CD offerings, as it allows for an “apples-to-apples” comparison regardless of their specific compounding frequencies. For example, if two CDs have the same interest rate but one compounds daily and the other annually, their APYs will differ. The daily compounded CD will have a slightly higher APY. Focusing on the APY helps determine which CD provides the greater overall return, making it the most important figure when evaluating options.