The Federal Deposit Insurance Corporation protects your certificates of deposit, making them a good choice for keeping your money safe. Though you could potentially earn a higher rate of return in more risky investments, the FDIC insures all your accounts – checking, savings, CDs and money market – up to $250,000 per bank. You can’t lose your money, even if the bank goes out of business. But that doesn’t mean all CDs are the same. One important difference is how often each CD compounds interest because the difference can make a noticeable difference in how much interest you’ll actually earn over the life of the CD.
When a CD compounds interest monthly, interest accrues on the principal at the end of each monthly cycle. This results in a noticeable increase to principal over the course of a year. In an annual accrual, interest will only be added back on to the balance at the end of the year.
The Effects of Compounding Interest
Each day, the bank keeps track of how much interest is due on the balance of the account based on the current amount in the CD, but that interest isn’t added until the interest compounds. The more often interest compounds, the higher the effective interest rate for the CD will be because each time interest compounds, the accrued interest starts earning additional interest.
For example, if one CD compounds interest monthly, it means that after the first month, that CD will add the interest so that it can earn additional interest over the last 11 months of the year. If another CD compounds interest annually, that CD won’t add any interest to the balance until the year ends.
Interest Rate Terminology
When you look at interest rates for CDs, make sure you know whether you’re looking at the annual interest rate or the annual percentage yield, sometimes abbreviated as APY. The annual interest rate doesn’t take into consideration the effects of interest compounding. The annual percentage yield tells you the effective annual interest rate you’ll be earning after interest compounding is taken into consideration. If the CD compounds interest annually, these two numbers will be the same. But, if it compounds interest more frequently than annually, the annual percentage yield will be higher.
Calculating Compound Interest
To figure out how much additional interest a CD that compounds interest monthly will earn each year versus a CD that compounds interest annually, you need to know the interest rate being offered. First, divide the interest rate by 100 to find the interest rate as a decimal. Next, divide it by 12 to calculate the monthly interest rate. Then add 1. Next, raise the result to the 12th power. Then subtract 1 to find the effective annual rate as a decimal. Finally, multiply by 100 to convert the effective annual rate to a percentage.
For example, say you are comparing two CDs that pay 3.72 percent for one year, but one compounds interest annually and one compounds interest monthly. To find out how much more interest you’ll earn by opting for the CD that compounds interest monthly, divide 3.72 percent by 100 to get 0.036. Next, divide 0.0372 by 12 to find that the monthly rate as a decimal is 0.0031. Then add 1 to 0.0031 to get 1.003. Next, raise 1.0031 to the 12th power to get 1.03784086. Then subtract 1 from 1.03784086 to get 0.03784086. Finally, multiply 0.03784086 by 100 to get 3.78 percent. That means that you’ll earn an extra 0.06 percent in interest by opting for the CD that compounds interest monthly.
Early Withdrawal Penalties
One drawback to using CDs is that they impose substantial penalties if you take the money out of the account prior to the maturity date. Just because the interest is added to your account monthly versus annually doesn’t mean that you can take it out any sooner. No matter how often interest compounds, you still need to wait until the CD matures to be able to withdraw the interest and principal without penalty.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."