How does compound interest work with CDs? (2024)

FAQs

How does compound interest work with CDs? ›

Like savings accounts, CDs earn compound interest—meaning that periodically, the interest you earn is added to your principal. Then that new total amount earns interest of its own, and so on.

Certificates of deposit (CDs) generally pay compound interest, meaning that the interest your CD earns will also earn interest.

However, our opinions are our own. See how we rate banking products to write unbiased product reviews. Depending on the bank, a $5,000 CD deposit will make around $25 to $275 in interest after one year.

The cons of CDs

With a savings account, the money is easily accessible in case of a financial emergency or a change in spending priorities. With CDs, you typically can't withdraw the money whenever you want—at least not without paying a penalty.

The more often interest is compounded, the more money you'll earn. Using our example above of $5000 at an interest rate of 4% for 1.5 years, increasing compounding from monthly to daily can give a little extra bump.

That said, here's how much you could expect to make by depositing $20,000 into a one-year CD now, broken down by four readily available interest rates (interest compounding annually): At 6.00%: $1,200 (for a total of $21,200 after one year) At 5.75%: $1,150 (for a total of $21,150 after one year)

In summary, a certificate of deposit gives you steady and safe returns. Investing $15,000 in a CD could lead to substantial gains, regardless of the CD's length. However, make sure you won't need that money while the CD is active because withdrawing early usually incurs hefty penalties.

With a rate that high, a $10,000 investment in a 5-year CD could potentially grow to over $12,000 by the end of the term — and that's without any additional contributions. That means the returns on your CD will significantly outpace the returns typically offered by traditional savings accounts, averaging about 0.45%.

The top nationwide rate in each CD term—from 6 months to 5 years—currently ranges from 5.20% to 6.18% APY. With a $10,000 investment in a top-paying CD, you can earn hundreds to thousands of dollars of interest on your money—and much more than if you keep it in a typical savings account.

What if I put $20,000 in a CD for 5 years? ›

How much interest would you earn? If you put $20,000 into a 5-year CD with an interest rate of 4.60%, you'd end the 5-year CD term with $5,043.12 in interest, for a total balance of $25,043.12.

How Are CDs Taxed? Interest earned on CDs is taxed as ordinary income at your individual federal income tax rate. This rate can range from 10% to 37% depending on your taxable income and filing status.

Better rates than most savings accounts: Typically, a 3-month CD will offer a better rate than a standard savings account, although it's usually on par or slightly less than a high-yield savings account rate.

Losing money in a CD is highly unlikely. However, it's not impossible. If you're thinking about opening one, read the fine print about early withdrawal penalties, and be sure to compare more flexible options that don't have a maturity date. And even if you decide to open a CD, don't set it and forget it.

But when it comes to long-term savings, Dave Ramsey cautions against opening a CD. In fact, he insists that CDs are really nothing more than glorified savings accounts with slightly higher interest rates. The problem with those rates is that they don't do a good enough job of keeping up with inflation.

Are CDs safe if the market crashes? Putting your money in a CD doesn't involve putting your money in the stock market. Instead, it's in a financial institution, like a bank or credit union. So, in the event of a market crash, your CD account will not be impacted or lose value.

For example, the bank offers a seven-month CD rather than a six-month term, which is more common. And instead of a 12-month CD, it offers a 13-month CD. Interest on the bank's CDs is compounded monthly and credited to your account monthly.

According to the FDIC, the average CD pays 0.23% to 1.85% APY, depending on the term length. However, many financial institutions pay higher CD rates than the national average. Online banks and credit unions often have competitive CD rates on a variety of terms.

Interest earned on a brokered CD is not compounded, as it is with a bank CD. 2 If you want compound interest from brokered CDs, you must reinvest your earnings in another account.

Common accounts that can generate compound interest include certificates of deposit (CDs), savings as well as money market accounts. You can also use the power of compounding by reinvesting the interest or dividends earned on bonds, stocks and real estate investment trusts (REITs).