How Certificate of Deposit (CD) Interest Works
Unpack the fundamentals of how Certificate of Deposit (CD) interest is earned, calculated, and received to optimize your savings.
A Certificate of Deposit (CD) is a savings option where individuals deposit a fixed sum for a predetermined period. It offers a set interest rate, allowing funds to grow predictably. Unlike a standard savings account, a CD locks in your money for its term, typically providing a higher interest rate. Funds placed in a federally insured bank or credit union CD are protected up to $250,000 per depositor.
Key Elements of CD Interest
CD interest accrues based on several components. The principal is the initial amount deposited. This is the base sum for interest calculations.
The interest rate, or nominal rate, is the stated percentage paid on the principal. This rate is fixed for the CD’s duration, providing a predictable return.
The term length specifies the duration the money remains deposited, ranging from a few months to several years. Longer terms generally offer higher interest rates.
The maturity date marks the end of the CD’s term, when the principal plus earned interest becomes available. Early withdrawals before maturity typically incur penalties that can reduce earnings.
Calculating Your CD Earnings
How interest is calculated significantly impacts CD earnings. Simple interest is calculated solely on the original principal, meaning interest earned each period remains constant. For example, a $1,000 CD with a 5% simple annual interest rate earns $50 each year.
Most Certificates of Deposit utilize compound interest, meaning interest is earned on the initial principal and on accumulated interest from previous periods. This “interest on interest” effect leads to greater returns over the CD’s term. The frequency of compounding (daily, monthly, quarterly, or annually) also affects earnings; more frequent compounding generally results in higher overall interest.
To compare different CD offerings, financial institutions use the Annual Percentage Yield (APY). APY accounts for the stated interest rate and the effect of compounding over a year, allowing consumers to compare CDs with varying compounding frequencies. While the interest rate is the nominal rate, the APY reflects the true annual rate of return, accounting for compounding.
Receiving Your Interest
Upon a Certificate of Deposit’s maturity date, depositors have several choices for their accumulated interest. One option is to reinvest the principal and earned interest into a new CD, often leading to greater compounding. Many CDs offer automatic renewal, rolling over funds into a new CD of the same term unless specified otherwise during a grace period.
Alternatively, depositors can choose to have interest paid out, either by transferring it to an external checking or savings account or by receiving a check. Payout frequency can vary, with options including monthly, quarterly, annually, or solely at maturity. This choice influences total return and fund liquidity.
Interest earned on CDs is generally considered taxable income by the Internal Revenue Service (IRS). This interest is taxed at ordinary income rates, similar to wages or salary, and is reported to the IRS on Form 1099-INT if interest earned is $10 or more. Taxes are owed in the year interest is earned, even if the CD has not matured or the interest has been reinvested. However, if a CD is held within a tax-advantaged retirement account, such as an Individual Retirement Account (IRA), taxes on the interest may be deferred until withdrawals are made.