Certificates of deposit are interesting financial animals. Just like savings accounts, CDs are insured by the FDIC, but you earn more interest with CDs and you can lock in interest rates for up to five years. Some banks and credit unions set minimum deposits at $2,500 or more, but you can usually find good CDs that start at $1,000. Although you must agree to leave the money on deposit until the CD matures, which can be challenging, your money will have more growth potential than if you had simply stuffed it into a low-interest savings account.
Compute the periodic interest rate by dividing the base annual percentage rate by the number of times each year interest is calculated and added to the CD’s balance (called compounding). For example, if interest on the CD is compounded monthly, divide the base percentage rate by 12 to find the periodic interest rate.
Multiply the previous balance of the CD by the periodic interest rate and add the result to the previous balance to find the new balance of the CD. Suppose you buy a $1,000 CD with an annual base interest rate of 4.8 percent compounded monthly with a periodic rate of 0.4 percent. The interest earned for the first month is $1,000 times 0.4 percent, or $4. The new balance is thus $1,004.
Repeat Step 2 for each succeeding month, but use the balance at the end of the previous month to calculate the current month’s interest.
Divide the total interest earned at the end of 12 months by the balance of the CD at the start of the year. Multiply the answer by 100 to convert to a percentage. Since the balance in the CD grows a bit each compounding period as interest is added, the amount of interest earned each compounding period also grows. Thus, your actual rate of interest on the CD is a little higher than the base rate. For example, a CD with a base rate of 4.8 percent compounded monthly yields an annual percentage rate of 4.91 percent.
- Some CDs give you the option of having interest earned sent to you instead of adding it to the balance of the CD, usually on a quarterly basis. When you choose this option, you get current income, but you lose out on the extra earnings that result from leaving the interest with the CD, where it will earn more interest.
- Some institutions offer variable-rate CDs for which the interest rate is adjusted periodically. You figure interest the same way you do for fixed-rate CDs, except you have to recalculate the periodic rate of interest each time the base rate changes.
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- How Do I Calculate Effective Interest Rate?
- How Does a CD Loan Work?
- Fixed vs. Variable Annuity Pros and Cons