A CD rate is the interest rate you get on a Certificate of Deposit, also called a CD.
The interest rates on CDs are usually higher than those on savings accounts.
With a CD, you typically commit to foregoing access to your money for a specific amount of time. Because you’re making that kind of commitment, banks generally pay you interest at a higher rate than on savings accounts.
There’s a bit more to know about how CD rates are determined and calculated. Let’s break this down.
APY, which stands for annual percentage yield, is how much interest you earn on your CD, including all compounding interest, after one year. Interest usually compounds daily, monthly, quarterly or annually. With compound interest, you earn interest on your initial balance at first, then after the first compounding period, you earn interest on your balance plus the interest you’ve already earned. This continues through the entire term of your CD.
Interest on interest on interest on interest. Pretty neat, right?
Let’s see an example of how this works:
Let’s say you put $10,000 into a CD with a 3-year term and 3% APY. (APY is how much interest you’ll get after one year. In this example, we’re compounding annually.)
The first year, you earn 3% of $10,000, or $300, in interest. This $300 in interest is added to your balance.
In year two, you get 3% of $10,300, which comes out to an additional $309 in interest. This continues for the length of the term.
A CD's APY is determined by both the interest rate and how often interest is compounded. The higher your APY, the faster your balance could grow.
Many online banks offer higher CD rates than traditional banks because they don’t have to pay as much overhead to maintain physical branches. Higher rates mean you can make more money.
APY is often confused with APR, annual percentage rate — but the two are different. APR is the amount you pay to borrow money, like with a credit card or personal loan. APY applies to savings accounts and CDs.
Typically, the longer the term on a CD, the higher your interest rate. This is because, when you commit to leaving your money with a bank for an extended time, institutions know they can use those funds for other purposes, like making loans to other customers, without the worry of you removing your funds from the bank.
Since this works to their advantage, they’re typically willing to pay you more interest. So that’s why the rate on a 5-year CD is often higher than the rate on a 1-year CD.
When the Federal Reserve raises interest rates, the APYs on CDs often rise, too.
That’s because banks and credit unions typically use the federal funds rate (or fed funds rate, for short) as a benchmark for setting their own interest rates. The fed funds rate is, generally speaking, the rate institutions charge each other for borrowing money; banks use it to determine how much interest they charge or offer customers. When the fed funds rate rises or falls, the interest rates that banks offer, including rates on CDs, generally follow.
That fluctuation is something you can avoid with a CD. When you open one, the rate typically won’t change for the entire term, even if the fed funds rate falls. Rates on new CDs would, however, be affected.
Knowing how CD rates work is helpful in choosing a CD. By using an online CD calculator, you can easily figure out how much interest you'll earn when your CD matures at the end of its term.
We hope you learned something.