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Understanding CD Rates
Dennis writes in with the following question about CD rates:
My credit union has CDs. The rate for a three-month CD is 1.88% while the rate for a one-year is 2.37%. Is my math reading correctly when I come out with $2.37 (on a $100 deposit) for 1 year but if I chose to deposit in the three-month CD four times in a row (thus equaling the 1 year CD) that my return would be $7.52 (assuming the rate remains the same)? At the moment I’m not debating whether or not a CD is the best investment, simply asking about this particular set up.
This is actually a fairly common misconception that people have about how certificates of deposit work. In truth, the one year certificate of deposit will earn you noticeably more than the three month CD. Let’s dig into how this all works.
CDs are quoted with their annual rates of return. When you see a rate quoted on a certificate of deposit, you actually are seeing the annual rate of return on that CD – in other words, that’s the percent of your investment that would be earned if you held the investment for a full year. So, the three month certificate of deposit above would earn 1.88% only if it were held over the course of a full year.
A very simple example So, let’s say Dennis buys one of those three month CDs. This CD only pays interest upon maturity and earns 1.88%. Dennis buys one for $1,000. Over the course of a year, this investment would have earned $18.80, but the CD only lasts for three months, thus earning Dennis $4.70 after three months. If he were to take that $1,000 and buy another CD, then do it again, and again, at the end of the year, Dennis would have earned his $18.80.
Compounding Many certificates of deposit compound monthly, which means they pay out 1/12th of the year’s interest at the end of each month. So, in the above example, Dennis would actually see an interest payment of $1.57 every month.
Many certificates of deposit also allow you to put that earned interest directly onto the balance of the certificate of deposit, meaning it would also earn interest along the way. Let’s say Dennis bought a three month certificate of deposit under these conditions for $100,000. At the end of the first month, the certificate would earn $156.67 in interest, which would then be added to the balance of the certificate, making it worth $100,156.67. At the end of the second month, the certificate would earn $156.91 in interest, bringing the balance of the certificate to $100,313.58. At the end of the third month, the certificate would earn $157.16 in interest, at which point the certificate would close. As you can see, compounding monthly is much better than compounding annually.
Buying a certificate of deposit When you go to buy a certificate of deposit, it’s not enough just to know the rate and the term. You also need to know how often it compounds (the more often, the better) and if that compounded money rolls into the balance of the certificate (if it does, that’s better). Although these factors aren’t enough to overcome a large difference in rates, they do make all the difference for small differences in rates.
Dennis, in your situation, if you’re wanting to put your money away for a full year, the one year certificate of deposit is the best option. Buying consecutive three month certificates will not earn you as much as the one year certificate will.