What Is a Certificate of Deposit?
Certificates of deposit are time deposit accounts. They earn a fixed rate of interest on the money you invest for a fixed period of time. Unlike a savings account, CDs generally don’t allow you to withdraw the principal at any time during the term. If you withdraw money before the maturity date, you’ll often pay an early withdrawal penalty fee.
How Do CDs Work?
CDs lock up your money for a set period. In exchange, the bank or credit union pays an interest rate generally higher than rates found on a savings account. Banks and credit unions offer CDs and certificates in a variety of terms.
Typically, the longer the term, the higher the interest rate. However, recent pandemic-fueled uncertainty in the U.S. economy has caused some banks to price CDs differently, such as paying the same rate for all terms, or paying a higher APY for a shorter term.
How Are CD Rates Determined?
CD rates are set like other banking rates. Banks and credit unions often use an index rate, typically the federal funds rate (also known as the “fed rate”), as a base to set rates for all interest-bearing accounts. When the fed funds rate rises, banks and credit unions will generally increase the interest rates on accounts like savings and CDs. When the fed funds rate falls, banks will then lower their rates on those same accounts.
The Federal Deposit Insurance Corporation (FDIC) tracks rates on deposit and Treasury instruments each month. When comparing CD rates, you can use the FDIC chart to see how well a particular bank or credit union’s CDs stand up against the national averages.
In addition to tracking current interest rates in the economy, banks and credit unions set rates based on a CD’s term. Generally, the longer you keep your money in a CD, the higher your interest rate. However, this is not always the case, and banks and credit unions may feature or promote individual terms at higher rates.
How To Calculate CD Rates
CD rates are set by banks and credit unions based on factors like the term length and the current interest-rate environment. The highest rates are typically reserved for longer CD terms.
Certificates of deposit carry fixed interest rates, making it easy for individuals to calculate the exact return to expect. You can calculate your guaranteed return on a CD using the following information:
- Your initial deposit
- CD term length
- Interest rate
- Compounding frequency
You can also use a CD calculator to determine how much interest you’ll earn with a CD. For example, if you opened a 12-month CD earning 2.50% APY and deposited $1,000, you’d earn $25 over the course of one year. If you chose a 24-month CD with that same rate, you’d earn $50.62 by the end of two years. Plug in different term lengths or deposit amounts to see how it affects the overall savings earned.