What is a Certificate of Deposit (CD)?
A certificate of deposit is very similar to depositing money into a savings account – the biggest difference being that the money in the CD is usually “locked in” for a period of time (and because of that typically is rewarded with a higher interest rate).
How is the Interest Rate on a CD calculated?
Compound interest on a CD is calculated using a simple time value of money financial formula.
It is important to note that the interest rate result is for each compounding period – to find Annual Percentage Rate (APR) it is then adjusted to an annual rate (for example if the CD is compounded monthly, the Interest Rate result would be multiplied by 12 to find the APR)
A depositor has $1,000 to deposit and has a savings goal of $1,020 over 36 months. The bank that holds the CD compounds the interest Monthly.
Therefore, to reach this savings goal, the CD would need to have monthly interest rate of 0.00055022, or 0.055022%, or 0.66% Annually
What is the initial deposit?
The initial deposit is the amount initially invested in the CD.
What are months?
Months are the amount of total time that the investment is held in the CD.
Most CDs are invested in a period of years, however there are some that are invested for shorter terms (or partial years).
What is the annual interest rate?
This is the interest rate that is earned annually on the deposit.
The annual interest rate is different than the annual percentage yield (APY).
What is the compounding period?
The compounding period is how frequently the account is updated with each interest deposit.
Shorter compounding periods typically yield more interest over the term than longer compounding periods with the same interest rate.
Sources and External Resources
- Wikipedia – Time Deposit
- Wikipedia – Certificate of Deposit
- FDIC – Insured or Not Insured?
- SEC – High Yield CDs – Protect your money by checking the fine print
- FDIC – Thinking of buying a CD? What to consider before handing over your money