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How Do CD Accounts Work?
If you’re looking for a way to earn more money on your savings, a certificate of deposit (CD) may offer a solid return. In exchange for earning interest and avoiding a financial penalty, you agree to keep money in a CD for a set period of time.
Banks, credit unions, and other financial institutions enable customers to open CDs with a variety of terms, minimum deposit amounts, and interest rates. CD terms usually range anywhere from one month to 10 years. Generally, a longer term results in a higher interest rate and more earnings over time. However, a financial institution might run a promotion that offers a higher interest rate for, say, a 10-month CD than you might find for a 10-year CD.
Some CDs require no minimum initial deposit, while others might require a deposit ranging from $250 to $2,500.
Interest Rates for CDs
When choosing a CD, pay close attention to the annual percentage yield (APY) that you can earn. The APY indicates how much interest you’ll receive over the course of a year, including the basic interest rate for the CD as well as the compound interest.
If the APY is 4%, that means you’ll earn 4% of your total account balance as an interest payout every year. With a 4% APY, a $1,000 CD with a one-year term will accrue $40 by the time the account matures. Compound interest—the interest you earn on interest—is added to a CD on a daily, monthly, quarterly, or annual basis, though it’s usually done on a daily or monthly basis.
The APY for a CD typically remains the same for as long as the account is open.
Reasons to Open a CD
You might open a CD when you want to:
- Make high interest rates work in your favor: In some cases, a CD might pay a higher interest rate than a traditional savings account.
- Build up savings in a low-risk account: Most CDs are federally insured by either the Federal Deposit Insurance Corp. (FDIC) or National Credit Union Administration (NCUA).
- Achieve relatively short-term financial goals: This might include saving money for a down payment on a home, a home renovation project, or a big vacation.
Ideally, you should put money in a CD only when you don’t think you’ll need that cash before the CD’s maturity date. Why? Because you’ll likely be hit with a penalty if you withdraw money early. The penalty might mean that you give up six months of earned interest, for example, if you pull money out before the maturity date for a three-year CD.
How Do You Calculate Interest on a CD Account?
Calculating the compound interest for a CD involves some math and a few pieces of information. You’ll need to know the following:
- Principal (initial deposit)
- Interest rate
- Number of times the interest compounds per year
- CD period (such as three years)
Once you’ve gathered that information, you can plug it into the following formula:
A = P(1+r/n)nt
- P is the principal (the starting amount)
- r is the annual interest rate, which is written as a decimal
- n is the number of times the interest compounds each year
- t is the time, or total number of years
- A is the total amount you will wind up with at the end of the timeframe
Are you frightened by math? If so, don’t fret. If you’d rather visit the dentist than calculate compound interest for a CD, plenty of online calculators are available to make the task much less painful.
Examples of How CD Returns Work
Whether you figure out a CD’s returns using a formula or an online calculator, you’ll come up with results that look like the ones in the following chart. The information in this chart is based on a $2,500 initial deposit with interest compounded daily and annually at an interest rate of 3.5%.
You’ll notice the dollar amounts are higher when the CD period is longer and when the interest compounds daily versus annually.
| CD Term | Compounds Daily (3.56% APY) | Compounds Annually (3.5% APY) |
|---|---|---|
| One year | $2,589 | $2,588 |
| Two years | $2,681 | $2,678 |
| Three years | $2,777 | $2,772 |
| Four years | $2,876 | $2,869 |
| Five years | $2,978 | $2,969 |
How to Increase Your Interest Yield on a CD Account
When you’re shopping around for a CD, you can take advantage of a number of ways to boost the APY. Here are four of them:
- Look for a High APY: To find an attractive APY, shop around. Compare APYs at several financial institutions, considering available term lengths, deposit requirements, early withdrawal penalties, account fees, and other factors.
- Deposit More Money: When you set up a CD, figure out whether you can afford an initial deposit of, say, $2,500 rather than $1,000. Unless you withdraw money before the maturity date, you should collect more interest over time with a larger deposit. Keep in mind that you normally can’t add money after you’ve opened a CD.
- Hunt for Promotions: Some financial institutions offer limited-time promotions that let you earn a higher APY than you typically would on a six-month CD, for example.
- Seek Out Relationship Bonuses: If you already maintain an account at a financial institution, you might be able to score a higher “relationship” bonus on a CD rate because you’re an existing customer.
The Bottom Line
You might find that the returns on CDs are attractive—and perhaps more attractive than the returns for a traditional savings account. To calculate CD returns, you’ll need to be armed with information such as the initial deposit amount and the account’s interest rate, and then plug that data into a formula or an online calculator. Doing this calculation might help improve your overall savings strategy and put you on the path toward achieving your financial goals.
For any mortgage service needs, call O1ne Mortgage at 213-732-3074. We’re here to help you achieve your financial goals with the best mortgage solutions available.
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