Certificates of deposit are investments offered by banks and brokerage firms in which the investor commits to leaving money in the certificate of deposit for a specified period of time in return for giving the investor a guaranteed rate of return. This interest rate is usually higher than other bank accounts, because the bank can count on the money remaining in the account for the duration of the certificate of deposit and therefore invest it in longer-term investments that yield a higher rate of return. If the money is withdrawn early, the investor will have to pay a severe penalty, often several months worth of interest.
What is a Coupon?
A coupon is the stated rate of interest on the certificate of deposit. The term comes from bonds that have coupons that must be torn off the original bond and redeemed to be paid the interest due. The interest rate specified by the coupon is paid at set intervals.
Zero-Coupon Certificates of Deposit
Zero coupon certificates of deposit are those that do not have any interest payments on the account until the maturity date. These certificate of deposit are usually priced below their actual value to attract investors.
Under U.S. tax law, the investor must pay taxes on interest as it is accrued rather than as it is paid. This means that if you invest in a zero-coupon certificate of deposit that will mature in 5 years, you are responsible for paying taxes on the interest accrued in the first year when you file your taxes even though you won't physically be paid that money until the certificate of deposit matures several years later.
Calculating Accrued Interest
To calculate how much interest has accrued on your zero-coupon certificate of deposit, use the formula below where P is the principal, R is the annual rate, and T is the amount of days since interest was paid:
Accrued Interest = P R / 365 T
For example, if you invested $10,000 in a certificate of deposit that paid an annual interest rate of 3 percent, after 100 days you would have accrued $82.19.
Other CD Payment Methods
Most certificates of deposit pay interest at fixed intervals throughout the term, rather than waiting to make one lump sum payment when the certificate of deposit matures. These certificates of deposit either pay out the interest to the investor reinvest the interest back into the certificate of deposit. If it is paid out, the investor will either receive a check or the money will be transferred into another account. This method is preferable for people who have invested in a certificate of deposit to have a fixed income. If the money is reinvested, it is added to the principal of the certificate of deposit so future interest payments will increase. This is preferable for individuals who have no need for the money and are investing in the certificate of deposit for the interest rate it offers.
Tax Benefits for a Certificate of Deposit
Certificates of deposit (CDs) are not glamorous investments. You don't hear people bragging about investing in CDs, but there are tax advantages...