With today’s higher interest rates, certificates of deposit are becoming an increasingly popular savings choice. But, as with many savings products, understanding the interest rate—and the specific way it’s calculated—can make a difference in the return on your investment.
In this post, we’ll offer a basic primer on how compounding and non-compounding (simple) interest rates are calculated and why knowing the difference can lead to big payoffs, especially in your long-term investments.
What is Simple and Compound Interest in Investing?
There are different ways that financial institutions can calculate interest for loans and investments, like savings accounts and CDs. Two common ways include simple interest and compounding interest.
When banks offer simple interest, you get interest only on the initial funds you invest. Simple interest is calculated by multiplying the original amount (P, for principal) by the annual interest rate (r) and the length of the investment, like the CD term, (n), in years:
Simple Interest = P × r × n
For example: If you have opened a $5000 CD with a 4% interest rate and an 18-month (one-and-a-half year) term, you would calculate it like this:
5000 × .04 × 1.5 = 300
When the CD comes to maturation, you’ll have earned $300 in interest.
Compound interest is more complicated to calculate because you are adding in the interest previously earned to the principal on a regular basis (usually monthly), and using that total to calculate interest earned—in other words, getting interest paid on your interest already earned, as well as the principal you invested. It’s easy to use a savings calculator to figure out the interest you’ll earn. But if you love doing math, you can also use this formula to calculate compound interest:
Compound interest = P(1 + (r/12) )12t – P
Here, t=number of years interest is applied.
Using the same example above of a $5000 CD at 4% interest invested for 18 months, the equation would look like this:
5000 × (1+.04/12)) × 12(1.5) – 5000 = $308.65
Your total interest earned would be $308.65.
Essentially, simple interest means the amount of money increases by the same amount each year, while compound interest means the amount of money increases by the same proportion each year. If you are getting a loan, simple interest will lead to paying less interest—which is ideal. But with investments, you’ll get a higher return with compound interest.
How Much Difference Can Compounding Interest Make in a CD?
In the example above the difference was marginal, and in many cases, there may only be a few dollars difference. However, as you change certain factors, the effects can be more dramatic. These factors include:
- How often interest is compounded
- The interest rate
- Amount of investment
- The length of the CD
First, let’s look at what happens when you increase the frequency of compounding. While most CDs are compounded monthly, sometimes interest is compounded more frequently (like every day), or less frequently (yearly or quarterly). 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. Your simple interest earned is the same ($300). Compounded interest would increase a little with daily compounding, from $308.65 to $309.18.
Now, let’s take the same CD above but increase the interest rate to 5%. With simple interest, the return would be $375, while with compounding interest, you would earn $388.58.
What happens if you increase your investment amount? Let’s say you have $10,000 instead of $5000 to deposit into a CD. With simple interest, you’ll earn $600. With compounding interest, you’ll earn $617.31.
Ultimately, with compounding interest, the biggest effect will come with time. Finally, let’s take the same example and increase the length to 3 years (renew CD 1 time). For 3 years, with simple interest, the return is now $600, while with compounding interest, it’s $636.36.
While $36 in extra cash for one CD is a nice little windfall, it might not seem substantial. But when you consider a lifetime of investments—for instance, saving for college or retirement—it can be monumental. Over 18 years or 40 years, with compounding interest, that $5000 initial deposit will grow to $10,259.87 (18 years) and $24,699.36 (40 years). With simple interest, your total investment will only be $8,600 (18 years) and $16,000(40 years)—possibly not even keeping up with inflation.
What is APY, then?
APY, or annual percentage yield, is a way to measure the amount of money earned on an interest-bearing account with compounded interest over the course of a year. It takes into consideration the frequency that your account compounds and expresses the total interest you’ll earn as an easy-to-read percentage.
Technically, you can calculate APY with this formula: (1+r/n)n – 1, but it’s easy to use an APY calculator to quickly figure out your APY. Additionally, when you open a CD, you’ll usually be presented with both the interest rate and the APY, which will be a little bit higher. In our example above, the APY would be 4.074%.
Why Should I Get a CD from a Local Bank?
Certificates of deposit are an easy way to earn interest on your savings—especially those you don’t need to access in the very near future. And with a variety of rates and term lengths to choose one, you can customize your CD to fit your needs while maximizing interest. Here are some of the benefits of investing with CDs:
- Higher Interest Rates: Local banks may offer higher interest rates on their CDs than national or larger financial institutions. And CDs almost always have higher interest rates than statement savings accounts.
- FDIC Insurance: Most banks, including Flanagan State Bank, are FDIC-insured. This means your deposit, like a CD, is insured for up to $250,000, making CDs an exceptionally safe form of investment—especially compared to market investments like stocks and mutual funds.
- Guaranteed return: Unlike market investments, whose rates can go up or down, your rate of return is also guaranteed, as long as you keep your money in the CD for its entire duration.
- Flexibility: With so many options for choosing CDs, from varying term lengths and minimum deposit amounts to interest rates, there is a CD out there for everyone, no matter your budget or saving needs.
- Convenient access: With convenient, local branches, you’ll be able to easily manage your CD and access your funds when your CD comes to maturity.
Open a CD at Flanagan State Bank
At Flanagan State Bank, we offer an assortment of choices with some of the best local CD interest rates. Whether you’re saving for goals like college or just want to make the most out of your idle cash, CDs offer both flexibility and security and are great investment tools to add to your saving strategy.