How does compound interest work with CDs?
Your savings is a crucial part of your financial plan. A healthy savings account helps you cover unexpected expenses, pay for large purchases and achieve your financial goals without straining your budget or going into debt.
One of the safest and easiest places to put your savings is in a certificate of deposit (CD). These accounts offer high interest rates that are fixed for the life of the CD, allowing you to enjoy predictable returns on your money without the stress and risk that come with other financial products, like stocks.
Better yet, these returns can grow exponentially over time thanks to something known as compound interest.
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How does compound interest work with CDs?
There are two kinds of interest you can earn on a deposit account: simple and compound interest.
Simple interest is calculated based only on the principal amount you deposited. For example, if you invested $1,000 in a 5-year CD with a 5% annual interest rate, you would earn $50 in interest each year if that CD accrued simple interest.
Compound interest, on the other hand, is calculated based on the principal amount plus any interest you've earned to date. This means that over time, your earnings will increase. Most CDs compound interest at a monthly or quarterly frequency, but some compound annually. The more frequently interest is compounded, the more you'll earn.
Using the above example, say you invest $1,000 in a five-CD with a 5% annual interest rate, but this CD accrues compound interest. If the interest is compounded annually, at the end of the five years, you would earn $276 in interest. However, if the interest is compounded monthly, you would earn $276.65 in interest.
Find out how much you could be earning with today's top CDs.
How to maximize the benefits of compound interest
Compound interest automatically earns you more than simple interest. But here's how you can get the most from this benefit.
Shop around
Not all CDs are created equal. Different banks and credit unions offer different rates, so it's important to compare CDs from several institutions to find the one that will pay you the most.
Choose the right term
The more you deposit and longer your CD term, the higher your earnings will be. That said, a longer CD term isn't necessarily the best for everyone.
Take the time to weigh the pros and cons of short- and long-term CDs and choose the term that best suits your goals and needs. Keep in mind that withdrawing your money before the end of the term can result in penalties, so be sure to choose a term length that works for you.
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Create a CD ladder
CD laddering involves investing in multiple CDs, each with a different maturity date. When one CD matures, you can withdraw the funds or reinvest them in a new CD. This give you regular access to your funds while allowing you to capitalize on future rate increases.
The bottom line
Compound interest is a useful tool — one that can help you grow your savings faster over time. However, to reap the biggest benefits from it, you must be smart about which CD you choose. Shop around, decide which term is best for you and consider building a CD ladder to find the right mix of liquidity and high returns.
Then, sit back and watch your earning accrue with no further action on your part!
