How Does Interest Work on a CD Account?

Building a nice nest egg goes beyond hard work and frugal living. To maximize your retirement, you want your savings to grow. Certificates of deposit, or CDs, are worth exploring because they offer higher interest rates than savings accounts and are federally insured up to $250,000. The downside to CDs is the investment and accrued interest are inaccessible for a set time without paying a penalty for early termination.

Annual Percentage Rate

Annual percentage rate, or APR, describes the CD's annual simple interest rate which does not include compounded interest. As an example, a CD that offers 5 percent interest would gain $500 on a $10,000 CD, calculated as 0.05 x $10,000. However, most CDs pay compound interest, so the annual percentage yield, or APY, more exactly describes the CD's accrued interest.

Annual Percentage Yield

APY describes the CD's interest rate including any compounding effect of periodic payments. This means that your interest also accrued interest.

To continue with the prior example, if the 5-percent CD compounded every six months, then it accumulates 2.5 percent interest twice per year, calculated as 5 percent divided by the two semiannual payments. However, the first payment is added to the original investment before calculating the second interest payment. Therefore, the first payment is $250 (0.025 x $10,000), but the second payment is $256.25 (0.025 x $10,250). The two payments total $506.25. Dividing this total by $10,000 gives you an APY of 0.0506, or 5.06 percent.

Calculating Total Interest

Although APY describes the true annual return, it doesn't calculate your total accrued interest which uses the standard compound interest formula. It works like this:

  1. Adding 1 to the periodic interest rate and raising the total to the nth power, where "n" is the number of periods until maturity, gives you the multiplication factor.
  2. Multiplying this factor by the original investment calculates the total at maturity.
  3. Subtracting the original investment from this figure gives you the total interest accrued.

If the example CD matured in 15 years, add 1 to 0.025 to get 1.025. Raise 1.025 to the 30th power (there are 30 semiannual payments in 15 years) to get 2.096. Multiplying $10,000 gives you a total of $20,960. Subtracting $10,000 leaves you with the total accrued interest of $10,960.

Exploring CD Maturity

All this interest is great, but unfortunately you don't have immediate access to it. Most CDs have a maturity date, which is a set time before you can cash in the CD to receive your original investment and any accrued interest. That means if you have a baby five years from now and need the money from the example's 15-year CD, you don't have that option without paying a penalty. Penalties discourage early cashing of CDs and severely undercut your return.

Understanding Call Options

Some CDs have a call option that allows the issuing institution to cancel the CD early. This forces you to cash in your CD early, although you do not suffer a penalty. The call option only applies to the institute; you still do not have the option for early cancellation without a penalty. Institutes may exercise this option if interest rates fall, which allows them to cancel high-interest rate CDs and reissue them to another investor at a lower interest rate.

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