Do CDs pay compound interest?
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, which is interest on the interest you’ve already earned. In this article, we’ll look at the difference compound interest makes with CDs and help you find a CD with the best interest rate.
Key points to remember
- Certificates of deposit (CDs) usually pay compound interest.
- This means that your interest also earns interest if you keep it on the CD.
- CDs are usually compounded daily or monthly.
- The annual percentage yield (APY) that CD issuers offer you takes capitalization into account.
- APY is the number to look for when shopping for a new CD.
Understanding CD Compound Interest
There is no law that says CDs have to pay compound interest, or that they have to be compounded at a certain frequency. It depends on each issuer. In practice, however, most CDs are compounded daily or monthly. The more frequent the compounding, the more interest your interest will earn.
How often your CD compounds is reflected in the annual percentage yield (APY) that the CD issuer promises you when you purchase 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 interest payments, such as monthly or quarterly, in which case that money will not be fully compounded.
To see the effect of compound interest on a CD, let’s take an example:
Suppose you put $10,000 into a one-year CD that pays 1% annual interest. If it was simple interest (i.e. not compound 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 the account pays compound interest and it is compounded monthly. To calculate 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, due to compound interest, you will 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 12 times in total, 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 bigger return with compound interest than with simple interest. However, you will also see that in this example the difference is minimal – only 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 compounded monthly would yield a total of $511.62, compared to $500 for a CD paying 5% simple interest.
Likewise, the difference that compound interest makes will be greater the longer you leave your money in the CD. A five-year, $10,000 CD earning 5% would earn $2,833.59 in compound interest at the end of its term, while a similar CD earning 5% simple interest would earn only $2,500.
There can be wide variations in interest rates from one bank or credit union to another, even on CDs of the same term. The highest-paying CDs can offer rates three to five times the industry average. So shopping around can be worth it.
Find the best CD rate
While compound interest is important, you don’t have to do the math for every CD you see.
This is because rates for CDs are usually quoted as an annual percentage yield (APY). This number already takes into account the effect of compounding, whether monthly or daily. If you see a 1-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 have earned 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% per month).
Is interest on CDs insured by the federal government?
How is interest on CDs taxed?
Unless your CD is in an IRA or other tax-deferred account (in which case your interest isn’t taxed until you withdraw it), interest paid by your CD is considered income and taxed at the same rate as your ordinary income. According to the Internal Revenue Service, “If you purchase a CD with a maturity of more than one year, you must include in your income each year a portion of the total interest owing.” If the amount is at least $10, the bank or credit union must send you a Form 1099-INT each year showing the interest you must report on your tax return.
Why are CD prices so low?
CD rates are tied to the federal funds rate set by the Federal Reserve. The Federal Reserve has kept this rate low for the past few years in order to stimulate the US economy. When it raises the rate again, as it began to do in early 2022, CD rates will eventually follow.
Certificates of deposit (CDs) generally pay compound interest, which means that the interest your CD earns will also earn interest. CD accounts are usually compounded daily or monthly. Compound interest is reflected in the annual percentage yield (APY) that the CD issuer quotes you, and APY is the percentage rate you should use when comparing CDs.