How Are CD Interest Rates Calculated?
Banks and credit unions offer CDs (certificates of deposit) to get and keep customers. CDs are insured by the FDIC or the National Credit Union Authority and pay higher rates of interest than regular savings accounts. This makes the CD a popular option for investors who want safety along with reasonably good income from their savings. All CD interest rates are calculated in a similar way, but there are some variations on the basic method that investors should be aware of.
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Identification
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CDs are fixed-rate time deposits. The financial institution offers a guaranteed rate of interest. In exchange, the customer agrees to leave the money in a CD on deposit for a specified period of time called the maturity. The base interest rate is an annual percentage (technically called simple interest). For example, if you purchase a $5,000 CD with a base rate of 4.0 percent, you might expect to receive $200.00 interest at the end of 1year. However, with almost all CDs, the base interest rate is compounded, meaning the accrued interest is calculated and added to the account several times during the year. Because the added money then starts earning more interest, you end up with a compound interest rate that is higher than the basic simple interest rate.
Features
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Interest calculations can be affected by a couple of factors. With many CDs, you can choose to have interest paid to you periodically (usually on a quarterly basis). For investors seeking regular income (such as retirees), this is the most common choice; however, you do forgo most of the extra earnings generated by compounding because the interest doesn't stay with the account. A more important consideration is the penalty for cashing in a CD early. Terms and conditions vary, but normally, if you do cash in a CD before its maturity, several months' interest will be forfeited, or you will receive a lower overall interest rate as a penalty.
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Compound Interest
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The first step in calculating compound interest on a CD is to convert the annual rate into a periodic interest rate. For some CDs, a period of 1 month is used, while others use 1 day. The annual rate is divided by the number of time intervals to get the periodic rate. Thus, the monthly periodic rate for a CD paying 4.8 percent would be 0.048 divided by 12, or 0.004 (0.4 percent). To find a daily periodic rate, divide the annual rate by 365. The starting balance in the CD is multiplied by the periodic rate, and the result is added to the balance to find the starting balance for the next period. This process can be repeated as many times as you need to (up to the maturity of the CD).
Interest Formula
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In practice, no one wants to manually calculate compound interest (especially if it's computed daily). It's much easier to use a formula that concisely expresses the process and can be conveniently entered into a calculator. To find the ending balance for a CD after any given time, use the formula E = S(1 + I)^P, where E is the ending balance, S is the starting balance, I is the periodic rate and P is the number of periods for which you want to calculate compound interest. The "^" is the standard text symbol indicating the following variable (in this case P) is an exponent. To find the interest amount earned, subtract S from E.
Considerations
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Suppose you buy a 1-year CD for $2,500 at 4.8 percent interest. Using only the base rate (simple interest), the CD earns you $120. However, if you leave the interest in the CD, and it's compounded monthly, your final balance is $2,622.68, and your interest earnings are $122.68 (if compounded daily earnings are $262.92). Either way, compounding earns you a little more money than simple interest alone even for short periods like 1 year. The effect of compounding is cumulative, and over several years, the difference becomes significant.
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