The ending value of your certificate of deposit, or CD, depends on how much you initially deposited, your interest rate, the maturity term of the CD, and the frequency of interest compounding. Here's a through discussion of how CD interest is calculated, as well as a calculator that can do the math for you.
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How CDs pay interest
There are two main methods used to calculate interest -- simple and compound. As the name implies, simple interest is the easier of the two to calculate, and means that interest is only paid on the principal balance of the account. In other words, if you invest $10,000 at 4% interest for three years, you'll receive an identical $400 interest payment during each of the three years. Bond investments typically use a form of simple interest, in that their interest payments are identical for the entire life of the bond.
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On the other hand, compound interest is a more complex mathematical calculation, but also is more beneficial to you as an investor.
The best way to describe compound interest is that interest is paid on both the principal, as well as any interest that has previously accumulated.
For example, let's say that $10,000 investment at 4% paid compound interest, calculated once per year. At the end of the first year, you would receive a $400 interest payment, just as you would under the simple interest method, giving you an account value of $10,400.
Beyond that is where it gets different. The second year's interest payment would be calculated as 4% of the new balance of $10,400, which is $416. This brings your total account value to $10,816. Finally, your third interest payment would be 4% of this amount, or about $433.
So, in this simplified example, compound interest would result in an ending value of $11,249, or $49 more than the simple interest method would produce.
In our simplified example, we considered interest compounded just once per year, also known as annual compounding. However, this isn't used too often in the real world.
Instead, interest is typically compounded more frequently, and while it's possible to use any interval, these are the most common:
- Semiannually: Twice per year
- Quarterly: Four times per year
I'll spare you the mathematics of how this works, but the basic idea is that the more frequently you compound interest, the more your money grows over the long run.
In our previous example of our $10,000 investment at 4% interest, check out the difference more frequent compounding makes, especially over longer time periods.
Table is author's own work.
So, how much will your CD be worth?
With all of this in mind, here's a calculator that can do the math for you:
* Calculator is for estimation purposes only, and is not financial planning or advice. As with any tool, it is only as accurate as the assumptions it makes and the data it has, and should not be relied on as a substitute for a financial advisor or a tax professional.
For example, let's say that I buy a $3,000 six-month CD at 1% interest. We'll say that the interest compounds monthly, and that I'm in the 25% marginal tax bracket. The CD calculator shows that at the end of those six months, my CD will be worth $3,015, and the interest I receive will add $4 to my tax bill for the year.
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