Before diving in, let’s start with the basics. A certificate of deposit (CD) is a deposit account with a financial institution. It lets you make a one-time opening deposit that earns interest over a fixed period. These accounts are FDIC insured up to the maximum amount allowed by law and CD interest rates are compounded periodically.
What is compounding interest?
Compounding interest is when the interest payment is added to the principal (original amount) periodically. The interest for the next interval is based on your new total. This differs from simple interest, where your interest per interval is calculated from the original principal.
By allowing you to accrue interest on your interest, compounding allows modest sums to potentially grow exponentially over time. Just ask the residents of Boston and Philadelphia, who got a firsthand lesson in the power of compounding from a founding father.
Benjamin Franklin and compound interest
Benjamin Franklin was a big believer in the power of compounding. In his will, the statesman and ambassador bequeathed roughly $2,000 to each of his favorite cities, Philadelphia and Boston. He stipulated the money should be invested using compound interest, with two payouts — 100 years after the date of the gift and then again at the 200-year mark. In 1991, a full 200 years after Franklin’s death, each city’s gift account boasted balances in the millions.
How are CD rates compounded?
In general, CD rates are compounded either monthly or daily, but this may vary by account. The more frequently a CD compounds, the more you may earn over a given term.
Monthly compounding
Monthly compounding is used by many interest-bearing CDs. Under this model, the annual interest rate is divided by 12 (the number of months in a year). The monthly interest earned is then applied to the principal amount, thus increasing your account balance on a set date each month.
Daily compounding
You may also find some CD rates are compounded daily, instead. The method of calculation is fairly similar to the monthly model, with one difference: your interest is compounded up to 365 times in a year, instead of 12. (Note that the exact number can vary between 360 to 365, depending on the institution.)
How much interest can you earn on a CD?
The amount of interest you can earn on a CD can vary based on several factors. See Chase’s current CD rates.
What is APY?
One way to compare different CDs is to look at their annual percentage yield (APY). This is the total amount of interest paid on the account based on the interest rate and the frequency of compounding for a year. Note that an APY isn't quite the same as your interest rate, though their values may often be close to each other. The interest rate is the rate at which your account appreciates per compounding period. The APY represents your total interest accrual for the year, expressed as a percentage of your original principal.
In summary
CDs offer a potential way for you to save and grow your money, since CD rates are compounded. They also carry the security of FDIC insurance up to the maximum amount allowed by law. When comparing your choices, the interest rate, compounding frequency and APY are all things to review before opening a new CD account. If you’re considering putting away some money to save, CDs may be an option.
