Don't be intimidated by the name—a certificate of deposit (CD) is just a savings account with a few additional conditions attached. For one, it's an account that is only established for a set amount of time, usually three months or longer. In addition, you cannot make small withdrawals from the account like you would a savings account. If you do make a withdrawal, you usually have to take the whole amount and the bank charges you a penalty. You can calculate a CD using an online calculator or just learn how to determine the estimated value at maturity by hand.
Define the terms of your hypothetical CD account. You need to decide on the length of the account, interest rate (depends on what the bank is offering), the initial deposit and the frequency of compounding (also depends on the bank). Say, for example, you establish a one-year CD with an interest rate of two percent with an initial deposit of $5,000 that compounds monthly. Monthly compounding means that the interest is calculated 12 times each year.
Enter the terms of your loan into a simple compounding interest formula ([(r/c)t+1]^c)P equals the CD value at maturity. The "r" represents the interest rate expressed as a decimal figure (.02 for two percent), the "c" is the number of times compounded in a year, "t" is the number of years you're holding the CD and "P" is the initial amount you deposit into the CD account.
Insert your hypothetical terms into the compounding interest formula. In this case, it's ([(.02/12)2+1]^12)5000, which equals $5,204 at maturity. The interest you've earned is $204 over two years for this CD.
- If you're getting a CD for less than a year, express the years ("t") as a fraction for the formula. For instance, three months is .25 years.