CD rates have been going in one direction over the past year: up. As the Federal Reserve has hiked interest rates, it’s translated to some good news for low-risk savers who are thinking about locking away their money in a certificate of deposit. If you’re one of them, it’s important to know how to calculate the returns on a CD to help you compare offers from different banks and credit unions.
Understanding CDs and their returns
A CD -- also known as a certificate of deposit -- is a low-risk saving product that you’ll find at most banks and credit unions (although they’re labeled as “share certificates” at credit unions). You won’t get your money back from a CD until it reaches the end of its term, or maturity date, unless you’re willing to pay an early withdrawal penalty that can wipe away your return. However, you may be able to withdraw interest at certain times -- monthly or quarterly, for example -- if you need extra income. To maximize your return, and to take advantage of compounding (more on that later), you shouldn’t touch any of the money in your CD.
Understanding interest rates on CDs
CDs are fixed-rate products, which means that you can lock in an interest rate that won’t change until the term is over. For example, if a bank advertises a 4% interest rate on a 12-month CD, you can open one tomorrow with the confidence that the 4% will remain the same until one year from tomorrow. That’s different from a savings account, which has a variable interest rate.
The interest rate, however, isn’t actually what you should focus on when trying to calculate your CD return. Instead, look for the APY, which stands for annual percentage yield. The APY reflects compounding interest, which is essentially earning interest on top of interest. Simple interest, on the hand, results in less earning potential: It’s just interest that accumulates based on the principal balance in the CD.
For example, if you deposit $30,000 in a 12-month CD with a 5% interest rate that pays simple interest, you’ll earn $1,500 at the end of the term. If it compounds daily, your earnings increase by $38.02 for a grand total of $1,538.02 in interest. The difference in APY between these two is 5% APY for the simple interest option and 5.127% APY for the compounding option.
Some banks compound interest daily while others might do so less frequently, such as monthly, quarterly or semi-annually. Look for CDs with daily compounding to earn more money.
Calculating CD returns: A step-by-step guide
One of the major benefits of owning a CD is that you can predict -- down to the penny -- how much you’ll earn. Here’s how:
- Figure out how much you want to invest in the CD. For the sake of this example, let’s say you want to put $50,000 in a CD.
- Make sure you’re comfortable with the term. Traditional CDs have early withdrawal penalties, which means that you’ll forfeit interest (and your return will be much lower) if you need the money before the maturity date. In this example, let’s say you feel comfortable locking up the money for 12 months.
- Compare APYs. After looking at a variety of banks that offer 12-month CDs, you find a CD with a competitively high interest rate of 4.8%.
- Do the math. Now, you have your most important inputs: The principal, the time and the interest rate. If your CD compounds interest only once a year, simply multiply $50,000 by 0.048, and you’ll see your total interest earnings will be $2,400. But, if your bank compounds interest on your CD daily, your total interest earnings will increase by nearly $60 to $2,458.37. Here’s the math:
Compounded annually: $50,000 x (1+(0.048 / 1))1×1 = $52,400.00
Compounded daily: $50,000 x (1+(0.048 / 365))365 x 1 = $52,458.37
Whether you’re calculating your CD’s total earnings using interest compounded annually or daily, the formula for compound interest is:
Initial balance x (1+ (interest rate / number of compoundings per periods)) number of compoundings per period x number of periods
Online tools and calculators for CD returns
You don’t have to break out your calculator or get lost in a sea of compounding frequency formulas to estimate your CD returns. Here are some of the best online tools and calculators to use to predict how much money you’ll have at the end of your CD’s term:
Bankrate’s CD Calculator: CNET’s sister site offers a CD calculator that’s helpful in illustrating how your potential return stacks up against the national average.
CIT Bank’s CD Calculator: CIT Bank pays some competitive APYs on short-term CDs (5% APY on its six-month CD right now and an 11-month no-penalty CD with a generous APY of 4.9% that lands the bank on our list of the best no-penalty CDs). But you don’t have to be a customer to take advantage of the bank’s handy CD calculator. We like this one because it gives you a good understanding of different compounding frequencies. If an interest rate looks attractive, use this calculator to determine the actual APY.
Ally CD Ladder Calculator: As an online bank, Ally’s lower overhead costs translate to some of the most competitive CD rates on the market. The bank’s CD ladder calculator is a very valuable tool for anyone who’s looking to estimate the returns beyond just one CD. If you’re planning a more sophisticated laddering approach, this tool can give you a solid estimate of what you’ll earn.
Fifth Third CD Maturity Calculator: The return you earn on your CD isn’t all yours to keep. You’ll need to pay taxes on the interest. Fifth Third’s calculator has an advanced function, which can help you estimate how much you’ll need to pay the government.
How to use these tools to calculate CD returns
All these tools are intuitive and easy to use. Make sure that you’re inputting the interest rate or the APY appropriately, as some ask for one or the other. And if you’re considering a slightly larger amount of money for a CD, be sure to use these calculators to get a sense of your potential increase in earnings.