Certificates of deposit (CDs) offer some of the best interest rates for an account with little or no financial risk. But if you’re not completely sure whether a CD is right for you, understanding how to calculate CD interest can help you compare your options and determine which one is the right fit.
Here’s the information you’ll need to calculate CD interest and the steps you’ll need to take to determine your return.
How to calculate CD interest
Before we get into the steps of calculating CD interest, it’s important to understand a few key terms. Once you have the proper information, you can run the numbers on a particular CD you’re considering.
CD terms to know
As you shop around and compare CDs, here are the most important features to keep in mind:
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Interest rate: This is the annualized rate the financial institution uses to calculate interest earned on your balance.
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Annual percentage yield (APY): A CD’s APY is a more accurate representation of what you’ll actually earn on your balance. The account’s APY is based on its interest rate, but it also accounts for compounding interest. As a result, it’s always higher than the interest rate.
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Compound frequency: Compounding interest means earning interest not only on your principal balance but also on the interest you’ve already earned on the account. A CD’s compound frequency dictates how often the financial institution calculates and adds more interest to your account.
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Principal: On a CD, your principal is the original amount you deposited.
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Term: Unlike savings accounts, CDs require you to hold your funds in the account for a set period of time (known as the term), which can range from one month to five years or more.
Calculating compound interest on a CD
There are several online resources to help you calculate CD interest. But if you want to crunch the numbers on your own, here’s the formula to calculate compound interest:
A = P(1 + r/n)ⁿᵗ
In this formula:
As an example, let’s say you’re thinking about depositing $5,000 in an 18-month CD with a 5% interest rate, and the bank compounds interest on a monthly basis. Here are the steps you’ll take to find out how much interest you’d earn:
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A = $5,000(1 + .05/12)⁽¹²⁾⁽¹.⁵⁾
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A = $5,000(1 + 0.004166666666667)¹⁸
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A = $5,000 x 1.004166666666667¹⁸
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A = $5,000 * 1.0777162109449
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A = $5,388.58
In this case, you’d earn $388.58 in interest on top of your original $5,000 principal deposit, resulting in a total balance of $5,388.58 at the end of the term.
Comparing different CD options
To give you an idea of how a CD’s compounding frequency and account term affect your earnings, here are some comparisons based on a $5,000 principal and 5% interest rate:
As you can see, the compounding frequency doesn’t make a huge difference, especially not compared to the account’s term.
Keep in mind, though, that CDs often offer varying interest rates for different account terms. If short-term interest rates are higher than long-term rates, for instance, you may be able to earn more money by choosing a shorter term.
Tips for getting a higher CD rate
If you believe a CD is right for you, here are some steps you can take to ensure you get the best return possible on your money:
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Shop around: While it may be convenient to open a CD with the financial institution you use for other banking needs, you may be able to find a better yield with another bank or credit union. In particular, online banks often offer some of the best CD rates because they don’t have the same overhead costs as traditional brick-and-mortar banks. Credit unions can also be a good choice because they generally offer better savings rates than traditional banks.
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Focus on APY: A CD’s APY accounts for compound interest, so looking at the APY when evaluating your options gives you an apples-to-apples comparison point for your total potential earnings.
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Carefully consider terms: Interest rates vary by term length, but it doesn’t always make sense to pick a CD for its higher rate if the term length doesn’t work for you. For instance, if you choose three-year term but know you’ll need to access the funds after a year, you’ll be subject to an early withdrawal penalty if you pull out your money before the CD matures.
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Watch out for minimum deposit requirements: Although some CDs don’t have a minimum deposit requirement, some financial institutions may offer higher interest rates to customers with large deposits. In some cases, the minimum deposit requirement can climb into the thousands of dollars, so make sure you only consider CDs that work based on your ability to save.
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Use the CD ladder approach: CD laddering involves spreading out your savings across multiple CDs with different terms. Staggering your maturities makes it possible to take advantage of higher interest rates with certain terms without tying up all of your money for a longer period of time.
The bottom line
CDs can offer better returns than a traditional savings account or money market account, but you’ll still want to calculate how much interest you can earn to evaluate whether a CD is a good choice.
As you take the steps to calculate potential interest and shop around to compare different options, you’ll be in a better position to determine if and how a CD fits in your overall financial plan.