Certificates of deposit offer a more secure, but typically lower, rate of return than other investments. On the flip side, they offer a higher rate of return than deposit accounts, like savings accounts, because you promise to leave your money in the CD for a certain amount of time. When you're investing in a CD, your actual return depends in part on how often interest compounds -- with daily compounding leading to a higher return.
Interest Compounding Function
Interest compounding refers to how often the bank adds the interest you earn on your CD to your balance. When interest is compounded daily, that means that at the end of every day, the bank calculates the amount of interest you earned that day and adds it to your balance. For example, if you have a CD that compounds daily, pays 3.65 percent per year and has a balance of $1,000, the bank would add 10 cents to your balance at the end of the day.
Effects of Daily Compounding
The more often your CD compounds interest, the higher your effective rate of return. See, when the interest gets added to your account each day, it increases the amount of money earning you interest in your CD. For example, when your balance increases from $1,000 to $1,000.10, that extra 10 cents earns you additional interest. It may sound small, but if you're investing a lot of money over a long period of time, it can add up.
Compound Interest Formula
To figure the amount of compound interest on your CD, you need to know your starting balance, annual interest rate and how long you're leaving the money in the CD. First, divide the annual rate, expressed as a decimal, by 365 to get the daily rate. Next, add 1 to the periodic rate. Then, raise the result to the power of the number of days interest accrues. Last, multiply the result by the balance to figure what your CD will be worth at maturity. For example, say you have a $1,000 CD paying 3.65 percent interest for 180 days. First, divide 0.0365 by 365 to find the daily rate is 0.0001. Next, add 1 to get 1.0001. Then, raise 1.0001 to the 180th power to get 1.01816206. Finally, multiply 1.01816206 by $1,000 to find your CD grows to $1,018.16 after 180 days.
Just because your interest compounds daily doesn't mean that you have the right to withdraw the interest whenever you want. Instead, unless you have a liquid CD, which allows certain withdrawals before the CD matures, having interest compound daily only increases the amount your CD will be worth at maturity, not when you can get the money out without penalty. The penalties can be quite severe. According to Bankrate.com, penalties averaged three months' worth of interest on CDs that last less than a year and six months' worth of interest for longer-term CDs.
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