Do CD Rates Pay Compound Interest?
In this guide, you will learn how Certificates of Deposit (CDs) work, including how they can earn interest.
CDs usually earn compound interest, a type of interest in which the interest you earn is reinvested into the CD and earns interest of its own.
One rate known as the annual percentage yield (APY) can help you understand the compound return you will receive on your investment. Read on to learn more about how CDs work and the most common financial terms you can expect to encounter.
What Is a Certificate of Deposit (CD)?
Banks have several ways to fund their operations, including shareholder equity, retained earnings, and debt. CDs fall into the debt category from the bank’s perspective.
When you purchase a CD, you exchange cash today for a promise from the bank to make regular interest payments to you until the CD reaches its maturity date. On that date, you have two choices:
- Roll your principal and interest over into a new CD.
- Cash out and receive your earnings, including the original principal plus the accrued interest.
CDs have the following components:
- An interest rate: CDs provide a fixed interest rate that remains the same throughout the term.
- Term and maturity: The length of time a CD pays interest is known as its term. Common terms include one year, three years, and five years. The date you may withdraw your funds from the CD is known as the maturity date. For example – a 15-month CD from Amerant Bank will mature after 15 months. If you open the CD in January 2023, it will mature in March 2024.
- Principal: The original investment you make in the CD is known as the principal.
- Terms and conditions: CDs each have their own rules and conditions, including penalties for withdrawing your money early and guidelines on whether you can withdraw the earned interest.
Like savings accounts, CDs have FDIC protection. This protection ensures your invested funds will be repaid by the government if the original issuer goes bankrupt.
Do CDs Pay Compound Interest?
Most, but not all, CDs earn compound interest. CD interest compounds when you reinvest your accrued interest into the CD.
However, if you opt to have your interest paid out each payment period, you will not enjoy the benefits of compounding.
CDs have two types of rates:
- Annual percentage yield earned (APYE): If you opt to have your interest paid directly to you each payment period, you will earn a rate lower than the APY known as the APYE. This excludes the effects of compounding.
- Annual percentage yield (APY): This rate assumes you reinvest all interest payments into the same CD. The APY accounts for the effects of compounding.
Is CD Interest Compounded Daily?
It depends on the type of CD you open, but CDs can compound interest daily. CDs with daily compound interest calculate the accrued interest and add it to the principal amount daily. In other words, the interest earned each day is added to the principal, and the following day, interest is calculated on the new total (principal + interest earned).
For example, say you invest $1,000 at an annual interest rate of 5% with daily compounding. The daily interest rate would be 5%/365 = 0.0137%. On the first day, you would earn $0.14 in interest ($1,000 x 0.0137%). On the second day, the new principal amount would be $1,000 + $0.14 = $1,000.14, and you would earn interest on that amount, and so on.
Monthly CD Compound Interest Explained
Monthly compound interest works similarly to daily compound interest, except that the compounding occurs each month rather than daily.
Less frequent compounding means your initial investment will grow slower, while more frequent compounding will yield greater gains.
To see the difference between daily and monthly compounding, let’s revisit the above example:
- You invest $1,000 in an investment with 5% interest compounding daily. After one year, you have accrued $1,051.27 in interest.
- You invest $1,000 in an investment with 5% interest compounding monthly. After one year (12 months), you have accrued $1,051.16 in interest.
What Is Annual Percentage Yield (APY)?
APY stands for “annual percentage yield,” which is a measure of the total amount of interest earned on a deposit account over one year, expressed as a percentage of the initial deposit amount. APY considers the compounding of interest over time.
Is Now a Good Time to Open a CD Account?
Whether now is a suitable time to open a CD account depends on your financial situation and goals, as well as the current interest rates and terms offered by financial institutions. Here at Amerant Bank, we offer promotional rates on CDs, e.g. 5.25% for a 15-month CD – click here to conveniently open a Certificate of Deposit with Amerant Bank.
For investors who want to earn a guaranteed return while saving for a short-to-intermediate goal, such as a home purchase or other large event, a CD can make sense regardless of the current rate environment.
Are CDs Better Than Savings Accounts?
If you have a specific savings goal and are willing to lock up your money for a set period, a CD may be a good option. However, if you need more flexibility with your savings or prefer to have immediate access to your money, a savings account may be a better choice.
The key differences between CDs and savings accounts include:
- Interest rates: CDs typically offer higher interest rates than savings accounts, but the rates are fixed for the term of the CD. Savings account interest rates can fluctuate over time.
- Access to funds: CDs require you to leave your money in the account for a set period, usually ranging from several months to several years, in exchange for higher interest rates. If you withdraw your money before the CD matures, you may be subject to penalties. Savings accounts allow you to withdraw your money at any time without penalty.
- FDIC insurance: The Federal Deposit Insurance Corporation insures both CDs and savings accounts up to a certain amount per account holder.
How CDs Are Taxed
CDs are taxable, which means the interest you earn on a CD is subject to federal income tax, as well as state and local taxes in some cases. The interest earned on a CD is considered part of your taxable income and must be reported on your annual income tax return.
The amount of tax you will owe on your CD interest earnings will depend on your overall income level and tax bracket. The interest earned on a CD is typically taxed at your ordinary income tax rate, which can range from 10% to 37%, depending on your income level.
If you have a CD in a tax-advantaged account, such as an IRA or 401(k), you may be able to defer taxes on the interest earned until you withdraw the funds from the account. However, any withdrawals you make from a tax-advantaged account before age 59 1/2 may be subject to a 10% penalty in addition to any applicable taxes.
It’s important to keep accurate records of your CD interest earnings and consult with a tax professional or use tax preparation software to ensure you are reporting your income correctly and taking advantage of any available deductions or credits.
CDs offer many benefits, and the power of compounding interest can help you save more money over the same period than saving it in a low-interest savings account.
Learn more about CDs at amerantbank.com and follow Amerant on Facebook, Twitter, Instagram, and LinkedIn @AmerantBank.
