A certificate of deposit is a savings account that traditionally pays a fixed interest rate that is more than regular savings accounts. The fixed rate is guaranteed until the CD matures, which is usually anywhere from three months to five years. CDs are low-risk investments because they are insured to $250,000 by the Federal Deposit Insurance Corporation. The profit you earn depends on the stated interest rate and the terms of the CD.
The terms of a CD account state the interest as an annual rate. However, interest is calculated and added to the balance of your account more often. Typically, interest is added on a monthly or daily basis -- a procedure called compounding. To accurately figure the profit on a CD, start by calculating the interest rate for a single period. Suppose you invest in a $1,000 CD with a 4.2 percent annual rate that is compounded monthly. Divide 4.2 percent by 12 months to find the periodic rate of 0.35 percent. To compute a daily periodic rate, you divide the annual rate by 365 instead of 12.
Computing the interest earned for one period is the next step in calculating your profit. Multiply the initial balance of the CD by the periodic rate. For a $1,000 balance and a monthly periodic rate of 0.35 percent, you have 0.35 percent times $1,000, which equals $3.50. Add the interest to the initial balance for a total of $1,003.50. Use this amount to compute interest for the next period. Your balance will be a little larger each time interest is computed and added to your account, so the amount of interest earned increases with each successive calculation.
Banks usually pay you the interest earned on CDs every three months. Once you’ve computed the compounded interest for one quarter, you have your profit for that quarter. If you want to know the profit for a year, simply multiply one quarter’s interest by 4. You might elect to leave interest in the CD account instead of having it paid to you. Since the interest keeps earning more interest, continue repeating the compounding calculation over a 12-month period to calculate your profit for a year. If a CD has a maturity of more than a year and you decide to let the interest accrue, you must continue the periodic compounding calculation until you have figured the total interest over the life of the CD.
Although the money in a CD account is insured, investors have interest rate risk. This means that when you agree to leave your money in a CD for a period of time, you take a chance interest rates will increase before the CD matures. If this happens, you are stuck with a choice between accepting a below-market rate or withdrawing your money early and paying a penalty. A second concern is that not all CDs have fixed interest rates. Some non-traditional CDs have a variable rate tied to a major indicator such as the prime rate. If you choose to invest in a variable-rate CD, you can’t calculate exactly what your profit will be in advance because there is no sure way of knowing what future interest rates will be, especially when the CD has a maturity of several years.