Certificates of deposit (CDs) generally pay higher interest rates than other types of savings accounts offered by banks and credit unions. Most also pay compound interest—that is, interest on the interest you've already earned. In this article, we'll look at the difference that compound interest makes to CDs and help you find a CD with the best interest rate.
- Certificates of deposit (CDs) typically pay compound interest
- That means your interest also earns interest if you keep it in the CD
- CDs generally compound daily or monthly
- The annual percentage yield (APY) that CD issuers offer you takes compounding into account
- APY is the number to look for when you comparison-shop for a new CD
Understanding CD Compound Interest
There is no law that says a CD must pay compound interest or that it must be compounded at a certain frequency. That's up to each issuer. In practice, however, most CDs compound either daily or monthly. The more frequent the compounding, the more interest your interest will earn.
The frequency with which your CD compounds is reflected in the annual percentage yield (APY) that the CD's issuer promises you when you buy a CD. The APY is calculated based on the assumption that you will leave your interest in the CD for its entire term. Some CDs allow you to take periodic disbursements of interest, such as monthly or quarterly, in which case that money won't fully compound.
To see the effect of compound interest in a CD, let's take an example:
Suppose you put $10,000 into a one-year CD that pays 1% annual interest. If this was simple interest (that is, not compounded interest), when your CD reaches the end of its term, you would have $10,000 + (1% x $10,000), or $10,100. That's a total return of $100.
Now, let's say that the account pays compound interest and it is compounded monthly. To work out the return with compound interest:
- First, we find the monthly interest rate. That's 1% divided by 12 months, or 0.0833%.
- After the first month, you would have $10,000 + (0.0833% x $10,000), or $10,008.33.
- In the second month, because of compound interest, you'll earn 0.0833% on this new total. So that's $10,008.33 + (0.0833% x $10,008.33), or $10,016.67.
- Do this a total of 12 times, once for each month of the year, and you'll end up with $10,100.46. That's a return of $100.46.
As you can see, you get a larger return with compound interest than you would with simple interest. However, you'll also see that in this example the difference is minimal—just 46 cents. If the interest rate were higher, the difference would be greater. For example, a $10,000 one-year CD paying 5% interest and compounding monthly would return a total of $511.62, against $500 for one paying 5% simple interest.
Similarly, the difference that compound interest makes will be greater the longer you leave your money in the CD. A $10,000 five-year CD earning 5% would collect $2,833.59 in compound interest by the end of its term, while a similar CD earning 5% simple interest would return just $2,500.
There can be large variations in interest rates from one bank or credit union to another, even on CDs of the very same term. The best-paying CDs may offer rates that are three to five times higher than the industry average. So shopping around can be well worth your while.
Finding the Best CD Rate
While compound interest is important, you don't have to do the math for every CD you see.
That's because the rates for CDs are generally quoted as an APY. This number already takes the effect of compounding into account, whether it is done monthly or daily. If you see a one-year CD that is compounded monthly and has an advertised APY of 1%, the amount of interest paid per month will be calculated by your provider, so that at the end of the year you've made exactly 1%.
This makes comparing CDs much easier. It also allows the bank or credit union to quote a more impressive return (in our example, 1% APY, rather than 0.0833% monthly).
Is the Interest on CDs Federally Insured?
The Federal Deposit Insurance Corporation (FDIC) and National Credit Union Administration (NCUA) insure CDs at participating banks and credit unions. Their coverage is capped at $250,000 per depositor, per institution, and per ownership category (such as a single or joint account). When interest is added to your CD balance, it gains insurance protection as long as you are within the limits.
How Is the Interest on CDs Taxed?
Unless your CD is in an individual retirement account (IRA) or another tax-deferred account (in which case your interest is taxed only when you withdraw it), the interest that your CD pays is considered income and taxed at the same rate as your ordinary income. According to the Internal Revenue Service (IRS), "If you buy a CD with a maturity of more than 1 year, you must include in income each year a part of the total interest due." If the amount is at least $10, the bank or credit union should send you a 1099-INT form each year showing the interest you need to report on your tax return.
Why Are CD Rates So Low?
CD rates are related to the federal funds rate set by the Federal Reserve. The Federal Reserve has kept that rate low in recent years as a way to stimulate the U.S. economy. When it raises the rate again, as it was beginning to in early 2022, CD rates will eventually follow.
The Bottom Line
Certificates of deposit (CDs) generally pay compound interest, meaning that the interest your CD earns will also earn interest. CD accounts typically compound daily or monthly. Compound interest is reflected in the annual percentage yield (APY) the CD's issuer quotes you and APY is the percentage rate you should use when comparing CDs.