When you consider different certificates of deposit for investment, it’s important to compare each one’s annual percentage yield instead of only the interest rate. While the interest rate is important in calculating your periodic interest payments, the APY factors in compounding and represents a CD’s true rate of return. This return is the total interest you earn annually as a percentage of your investment. Compounding is the effect of generating interest on your principal balance and on previously earned interest. A CD with a higher APY will grow your wealth more than one with a lower APY.
Find out a CD’s annual interest rate and the number of times it compounds, or adds interest to your account, per year from your bank or financial institution. For example, suppose a CD has a 2 percent annual interest rate and compounds monthly.Step 2
Divide the annual interest rate -- expressed as a decimal -- by the number of compounding periods per year. For example, 2 percent expressed as a decimal is 0.02; divided by 12, you get 0.00167.Step 3
Add 1 to the result. For example, add 1 to 0.00167 to get 1.00167.Step 4
Raise the result to an exponent equal to the number of compounding periods per year. In this example, raise 1.00167 to the 12th power to get 1.0202.Step 5
Subtract 1 from the resulting figure, and multiply by 100 to figure the CD’s APY. For example, subtract 1 from 1.0202 to get 0.0202. Multiply 0.0202 by 100 to get a 2.02 percent APY, or rate of return. This means that, each year, you will earn interest equal to 2.02 percent of the balance of your CD at the beginning of the year.
- The more compounding periods a CD has per year, the higher its APY is compared to its interest rate.