How Does Interest Work on a CD Account?
How Does Interest Work on a CD Account?. CD is short for certificate of deposit--a savings instrument used to gain a higher rate of interest in exchange for not having access to the money for a specified period. Calculating the interest over the term of the certificate of deposit depends on the interest rate, how often how the interest is paid, and how the interest is paid.
Most certificates of deposit have a fixed interest rate that is guaranteed for the term of the CD. These rates are usually higher than savings accounts or money market accounts, because the bank has the assurance that the money will remain with the bank for the stated length of time. The longer the term for the CD, the higher the interest rate.
How Often Interest is Paid
Different certificates of deposits pay interest at different times. Some pay quarterly; others pay monthly or annually. How often the interest is paid is especially important if it's reinvested in the certificate of deposit, because as soon as it's paid it will start accruing interest itself--which increases the amount of interest the certificate of deposit earns.
Interest can be paid through a check, transfer or reinvestment. When the interest is paid via check, the account holder receives a check in the mail at the end of each accrual period. When interest is paid through a transfer, the interest is automatically transferred to another account the holder has at the banking institution--such as a savings account or checking account. When the money is reinvested, it's added to the principal of the certificate of deposit and accrues interest in future periods until the CD matures.
Interest on CDs that Pay Out Interest
If you receive payments of the interest either by a check or through a transfer, calculating interest becomes easier because the interest payments are constant. In this case, determine the periodic rate. For example, if the certificate of deposit pays its interest quarterly, divide the annual interest rate by 4 to get the periodic rate. Then multiply the periodic rate times the principal and you get the periodic payment. So if you invested $1,000 in a certificate of deposit at a rate of 4 percent per year paid quarterly, the periodic rate would be 1 percent--which would result in a $10 payment four times per year for the term of the certificate of deposit. At the end of the term, you would receive the $1,000 back as well.
Calculating Interest on CDs that Reinvest Interest
Calculating the interest of a certificate of deposit that reinvests the interest requires the use of a different formula in which P is the principal, R the annual rate, N the number of times per year that the interest is compounded and T the number of years the money will remain in the certificate of deposit. Value at Maturity = P * (1 + R / N) ^ (N * T) For example, if you had $10,000 in a certificate of deposit that paid 3 percent per year, compounded the interest monthly, and was for five years, at maturity the certificate of deposit would be worth $11,616.17.
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