Updated on 02.23.09

Understanding CD Rates

Trent Hamm

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.

Good luck!

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  1. Frugal Dad says:

    Good explanation. This a good example of why I like the idea of laddering CDs. I like to know that I am only three months from having access to money in a CD, so the first year I bought a 3-month, 6-month, 9-month and 12-month CD.

    When the 3-month CD matured, I took the money plus interest and rolled it into a 12-month CD. When the six-month CD matured, I rolled the proceeds into another 12-month CD and so forth. By continuing this ladder I always have a CD coming due in the next three months, while taking advantage of the higher 12-month CD rates.

  2. Michele says:

    One thing I have noticed about my credit union is that they often have member specials where a shorter term CD does often have a higher rate. Unlike your example above, they sometimes have special teaser rates to get members to invest. For example, Navy Federal currently has a special 1-year paying 3.75% while longer term ones are less. Make sure you look at all rates if you are interested in investing in a CD.

  3. Jesse says:

    The other thing you have to consider is that for 1 year (or longer) CDs, you are locked in at that interest rate. The rates between consecutive 3 month (or shorter terms in general) could change and possibly be an advantage.

    When the times are a changin’ it may be best to consider what the interest rates could potentially be at the end of each term option.

  4. !wanda says:

    My savings account currently earns 2.45% (at HSBC). I’ve searched for the best CD rates online, but I’ve never heard of most of the banks that offer CDs that earn much higher than that. How can I tell if a bank is sketchy or not? Even if the account is FDIC-insured, I still don’t want to deal with a bank that might go under or one that won’t deal with me fairly.

  5. Gwen says:

    Wachovia is going to timed deposits instead of CD’s. Is it the same thing?

  6. Dave says:

    No offense to Dennis… but this is exactly why personal finance needs to be mandatory in schools.

  7. Anthony says:

    I recently had to roll over a maturing 12-month CD from ING, and was pretty disappointed with ING’s current yields. After doing a bit of digging, I found that all of the local credit unions (and some of the smaller-ish banks) were yielding much higher returns – in fact, I rolled it over to another 12-month at 3.60% APY at the local CU!

    I’ve been a little disappointed with Bankrate as of late, and have instead been checking out rates at local credit unions and banks against Internet banks. I’m curious to know where rates are in other parts of the country.

  8. Anthony says:

    The other thing to keep in mind is to make sure you’re comparing apples to apples. Some places will quote the APY, credit unions usually use a dividend rate and some places will even show an APR.

  9. George says:

    If you’re willing to take a touch more risk than a CD, many stable companies are offering decent dividend rates now. For instance, Pepsi (PEP) is yielding 3.40% at today’s share price and they’ve got enough cash on hand to maintain the current dividend for awhile. There are reasonably solid companies yielding much higher (e.g. MLPs such as APU, NRP, and OKS), but they come with more investment risk.

    Yes, there are definitely reasons for owning CDs, just pointing out that it might be possible, in a manner of speaking, to have your cake and eat it to. Just choose your risk allocations appropriately.

  10. Jennifer says:

    I work for Wachovia. A Time Deposit is the same thing as a CD. A CD is just a guarantee to keep the funds on deposit for a certain length of “Time” and in return you’ll get a guaranteed rate of return.

    All financial institutions, by Federal Regulation, must quote APY (Annual Percentage Yield), so that the consumer can compare apples to apples when looking at bank interest rates. This APY always takes into account the compounding method whether it’s Simple, Daily, Continuous, Monthly, Quarterly or Annually. (An APY of 2.75% will yield you the same amount at the end of the year, regardless of how the financial institution compounds and posts interest.)

    One other important thing to consider and confirm with your financial institution is whether you receive all accrued (built up) interest that has not yet posted to your account when you close the account. For example, I recall a credit union that I have dealt with for many years which does not pay out interest accrued if you close the account before the interest is posted at the end of the quarter.

  11. As a member of the banking industry, I happily get to say this is a perfect explanation.

    @Gwen, technically speaking, yes Timed Deposits are the same.

    Sadly, I have to agree with Dave on why personal finance should be taught in schools.

  12. Sandy says:

    We’ve had CDs for many years as our emergency fund. One thing that I would suggest to everyone is to always ask about special rates that the local bank that you deal with has to offer. For example, if you have a CD due, and forget about it, the bank will automatically roll over to the same time frame that you have, but at a lower, regular rate. When you actually go into the bank or CU, when your CD comes due, ask for any special rates. On the web site for my bank, it will say one thing, but when I go into my local branch, inevitably, they have a substantially higher rate available for, let’s say, 11 months, instead of 12, or 7 months instead of 6.
    Also, keeping up with market conditions is critical. My daughter saved up $1000 from babysitting and odd jobs, and we went to the bank to open her first CD. The special options were shorter term CDs, earning 2.75, or a 24 month earning 4.25. Being somewhat aware of what’s going on (and the fact that she’ll be using it for college in a few years)I suggested to her to take the longer term view. I realize that that’s not always the case, but it really does pay to be up on what the Fed is up to.

  13. Great intro on CD rates Trent!

    Best Regards,


  14. Chetan says:

    If higher CD rates cause you to look up, you might want to consider MoneyAisle – read more at http://www.sense2cents.com/2008/12/01/max-out-your-savings-using-moneyaisle/

  15. Dennis says:

    Well, they don’t teach personal finance in school so I had to ask.

    Trent – thanks for the explanation. Things are a bit clearer now.

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