How to Calculate the Return on Your CD

A certificate of deposit (CD)—or a share deposit at a credit union—is a time deposit savings account that earns a fixed interest rate for a set period, typically one month to five years. The amount of money a CD earns depends on four numbers: The initial deposit, the CD term, the interest rate, and the compounding interval. Here's how to calculate the interest you'll earn investing in a CD.

Calculating CD returns: a step-by-step guide

Unlike most investments, CDs pay a fixed interest rate for a set amount of time, so it's easy to estimate how much you'll earn. Here's how to calculate your earnings.

1. Decide how much to invest

Many CDs have a minimum opening deposit, such as $500, $1,000, or even $100,000 for jumbo CDs. You can't add more money after making that initial deposit. That means you should carefully consider how much to invest so you don't lock away too much or too little cash based on your financial goals.

2. Choose a CD term

CDs generally pay higher rates than other savings accounts. Still, there's a catch: If you need access to your money before the CD matures, you'll be hit with an early withdrawal penalty equal to several months (or more) of interest.

To avoid fees, choose a term that works with your cash needs. For example, if you're saving for a vacation you plan to take in six months, don't stash the cash in a 12-month CD (a high-yield savings account might be a better option). On the other hand, if you don't need the money for several years, you might consider locking in a competitive APY for a longer period while interest rates are still high.

Another option is to build a CD ladder, dividing your deposit into multiple CDs with different maturities. This strategy offers the best of both worlds: You can lock in favorable rates on the longer-term CDs while preserving access to your cash with the shorter-maturity ones.

Keep in mind that longer-term CDs don't necessarily have the best rates. Some of the highest APYs available today are with nine- and 12-month CDs.

3. Compare APYs

Online banks generally have the best CD rates. Still, it's worth checking rates at your local bank or credit union, especially if it offers loyalty rates or you prefer in-person banking.

4. Crunch the numbers

Once you know your deposit amount, CD term, and interest rate, you can calculate the return using the following formula:

Interest = (P * (1 + r / n) ^ (n * t)) – P

Where:

• P = the principal amount
• r = the interest rate (as a decimal)
• n = the number of times interest compounds per year
• t = the number of years

Here's an example. Say you invest $10,000 in a one-year CD with a 5% interest rate that compounds annually. Using the above formula, we can calculate the total interest as follows:

Interest = (10000 * (1 + (.05 / 1))^(1 * 1)) – 10000

Interest = (10000 * (1.05^1)) – 10000

Interest = 10500 – 10000

Interest = $500

You'll earn a bit more when the interest compounds monthly:

Interest = (10000 * (1 + (.05 / 12))^(12 * 1)) – 10000

Interest = (10000 * (1.00416667^12)) – 10000

Interest = 10512 – 10000

Interest = $512

Online tools and calculators for CD returns

While understanding the math is helpful, an online CD calculator is an easier (and quicker) way to see how much you'll earn. Numerous financial websites offer calculators, as do many banks and credit unions. Just enter your deposit amount, term, and APY to see an estimate of your earnings. Calculators can also be a simple way to compare options and find a CD that works best for you.

Understanding CDs and their returns

When you open a CD, you can't withdraw any funds before maturity without paying an early withdrawal penalty. The penalty might range from one to six months of interest, depending on the bank and CD term you choose. Penalties can reduce your earnings, and you could even take a loss if the penalty is higher than the interest you earned up to that point.

Of course, you'll avoid early withdrawal penalties—and the CD will continue earning interest—if you keep the CD until it matures. By default, the interest typically stays in the account and compounds. However, you can opt to withdraw the interest at fixed intervals, such as monthly or quarterly, if you need the income. Just keep in mind that doing so will reduce the APY since you'll only earn interest on the principal (i.e., the interest won't compound).

Once the CD reaches the end of its term, you have a couple of options. One possibility is closing the account; withdrawing the principal and interest; and spending, saving, or investing the money elsewhere. Alternatively, you can roll the CD into a new one at the then-current interest rate. If you don't choose an option before the CD matures, your bank will likely roll the CD into a new one automatically.

Taxes on CD earnings

The interest you earn on CDs is taxable as ordinary income the year it's paid—regardless of the CD's term or whether you withdraw or reinvest the interest. That means taxes will put a dent in your overall return. For example, say you have a five-year CD that earns $500 in interest the first year. Your bank will issue a 1099-INT form showing interest income for the year, even if the $500 remains in the CD.

Of course, you can postpone the taxes by holding the CD in a tax-deferred retirement account, such as an IRA or 401(k). In this case, you will receive a 1099-INT once you take distributions from the account. If you have a Roth IRA or 401(k), you may be able to avoid taxes on the CD income altogether.

It's worth noting that low-risk, tax-efficient investments such as municipal bonds and Treasury securities offer built-in tax benefits. For example, municipal bond income isn't subject to federal taxes and may be exempt from state and local taxes. Similarly, Treasury bills, bonds, and notes incur federal taxes, though they're exempt from state and local taxes.

Understanding interest rates on CDs

Most CDs have a fixed interest rate, meaning you lock in a rate for the entire term—whether interest rates are rising or falling. By comparison, savings accounts have variable interest rates, so you might earn 4% one month and 3% the next.

A special type of certificate of deposit called a bump-up CD or raise-your-rate CD works differently. With these CDs, you can request a rate increase to take advantage of rising interest rates. However, there's a caveat: You can usually request just one rate increase during your CD's term, though some banks permit two rate increases for long-term CDs.

While the interest rate is important, the annual percentage yield—APY—reflects the total amount you'll earn. That's because it considers compounding, which happens when you earn interest on interest (Albert Einstein once called compound interest the eighth wonder of the world). CD interest typically compounds daily or monthly. The more often it compounds, the more interest you'll earn.

TIME Stamp: CDs are a low-risk way to grow your savings

CDs can be an excellent way to boost your savings using cash you don't need immediately. They're considered low-risk investments because they offer a predictable, fixed rate of return. Most CDs are also insured: Deposits held at FDIC-member banks and NCUA-member credit unions are protected up to $250,000 per depositor, per bank or credit union.

Of course, CDs don't have the same earning power as higher-risk investments such as stocks, exchange-traded funds (ETFs), and mutual funds. Therefore, CDs might comprise only a portion of your overall investment portfolio, depending on your financial goals, risk tolerance, and time horizon. If you're uncomfortable investing on your own, consider working with a financial advisor who can help you build a well-diversified portfolio.

Frequently asked questions (FAQs)

How much does a $10,000 CD make in a year?

The interest a $10,000 CD earns in 12 months depends on the APY. For example, a $10,000 one-year CD will earn $400 with a 4% APY ($10,000 X 0.04=$400), $450 with a 4.5% APY ($10,000 X 0.045), and $500 with a 5% APY ($10,000 X 0.05). Of course, you may owe federal, state, and local taxes on those earnings, so you'll have to deduct the appropriate taxes to determine your exact return.

Who has the highest 12-month CD rate?

CD rates continuously fluctuate based on changing economic conditions, the Federal Reserve's monetary-policy decisions, and other factors. Still, online banks typically offer the best 1-year CD rates. With lower operating costs than brick-and-mortar banks, online banks can often pass those savings on to customers through better rates and lower fees. Interest rates remain elevated, and many online banks still offer APYs of 5% or more.

Where can I earn 5% on a CD?

Many online banks offer CDs with a 5% APY. While longer-term CDs have traditionally offered the highest APYs, the best CD rates today are available with shorter-term certificates of deposit, such as nine-month and 12-month CDs.