Most certificates of deposit offer a fixed interest rate for a specified term. However, different CDs can compound interest at different time intervals, which means that the interest accruing on your CD is deposited at different frequencies. So, understanding how often the interest compounds on your CD can help you make a better decision about which CD will pay the highest interest rate.
Interest compounding monthly means that the interest building up in your account gets added after just one month rather than at the end of the year. That way, the interest added after the first month earns additional interest over the remaining 10 months of the year. For example, a CD that compounds interest monthly at an annual rate of 3.6 percent is actually a better deal than a CD that compounds interest annual at 3.65 percent.
Calculating Effective Rate
To figure the effective interest rate on your monthly CD, especially when comparing it to the annual compounding option, first divide the interest rate as a decimal by 12. Then, add 1. Next, raise the result to the 12th power. Finally, subtract 1. For example, say you have a CD that compounds interest monthly and pays an annual interest rate of 3.6 percent. Divide 0.036 by 12 to get 0.003. Then, add 1 to get 1.003. Next, raise the result to the 12th power to get 1.0366. Finally, subtract 1 from 1.0366 to find the effective annual rate on the CD that compounds monthly equals 0.0366, or 3.66 percent.
Banks may list two different interest rates for the CDs that compound monthly, the annual interest rate and the annual percentage yield. The annual interest rate is smaller because it equals the monthly rate times 12 -- it doesn't account for interest compounding. The annual percentage yield equals the effective interest rate after accounting for compounding. For CDs that compound interest annually, the two numbers will be the same.
In most cases, how often the CD compounds interest won't affect when you can withdraw the money without penalty -- only how often the accrued interest gets added to your balance, so it will earn even more interest. However, some CDs, typically called "liquid CDs," allow you to take out a certain amount of your money without penalty before the CD matures. If that's the type of CD you have, the more frequent monthly interest compounding might allow you to take out more money earlier.
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