Bank CD Rates Explained
For many Bank CD rates explained in detail is need because of the complexity of the process. Before you will understand about the rates and how they earn money, you must first realize what exactly a certificate of deposit is.
A CD differs from a saving account and other types of accounts of financial institutions in various ways. The most distinguishing is the fact that until its maturity, the depositor has agreed not to withdraw their funds. The maturity is the time that is agreed to by the depositor and the financial institution when they accept the deposit. This maturity term can be anywhere from 1 day to 10 years. It is possible for the holder of the CD to withdraw the deposit early, but a financial penalty will occur.
A CD is really a loan to that financial institution for a specified time or term. The financial institution accepts these funds for that specific term. This cannot be done for free. When an individual takes out a loan, they must make additional payments for the privilege of borrowing that money. The same occurs when a financial institution takes out a loan from a depositor, they have to pay interest at a pre determined rate of interest.
There are several different types of interest that a CD can earn. Two of the more common ones are simple and compound interest.
Simple interest is like the name very simple. The interest that occurs on the deposit is only on the principal. If a deposit of $1000 is made for 2 years at 3% simple interest, then after one year the balance is $1030 and at the end of 2 years the balance is $1060. The depositor does not receive any interest on past interest payments.
Compound interest is more complex with many different types. This is where the interest that has been previously added to the principal receives interest in addition to the principal each time the interest is calculated. If the interest is compounded monthly then the interest rate is divided up into 12 separate divisions. One for each month the interest is compounded. For a $1000 deposit that receives compounded interest of 3% annually then each month the deposit will receive 0.25% interest. At the end of first month the deposit would have grown to $1002.50. At the end of the second month the deposit would then be $1005.01. This would continue until the CD matures with each month the principal and all the previous interest payments would be increased by 0.0025 or 0.25%.
Compound interest can become a very messy calculation but the basic formula is as follows.
The letters represented are defined as follows:
The A is the amount of your deposit after the specified time and all the interest has been calculated. The P is the initial deposit amount or $1000 from my example. The r is the interest rate at which you agreed to before you made your deposit in decimal form or from my example above would be 0.03. n is the number of times a year the interest was compounded or 12 from my example. t is the number of years the deposit is made for which in this case is 2.
This makes my earlier example as follows;
$1000(1+ (0.03/12)) exp 2*12= $1061.76
This shows the difference of $1.76 from simple interest and compound interest on a $1000 deposit that is compounded monthly. To figure the APY one must take the interest that was figured divided by the initial deposit the divided by the number of years the CD term is for and multiply by 100. With my example the equation goes;
(61.76/1000) /2 *100= 3.088%.
This example shows that the real interest earned, when compounded interest is used is expressed as the APY. If the compound interest is daily instead of monthly then the n value would be 365 and the total amount after 2 years would be $1061.83 with an APY of 3.092%
This proves that for the best rate on any CD would be interest that is compounded daily. The difference is not too significant in my example, but will factor in heavily with greater amounts of deposit. The easiest way to spot the best deal is with the APY. This is the reason CD’s at different financial institutions can have the same interest rates but different APY’s. It is all in the frequency of the compounding of the interest.
What investors have to be aware of when comparing Bank CD rates at different financial institutions is to notice the interest rates, what type of interest it is, the frequency of the compounding and the APY.
Simply put, Bank CD rates explained is best done by looking at the APY for the best return on your investment.
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