Calculating the Return on a CD

Anyone who is looking through the sea of investment opportunities is bound to come across the mention of a certificate of deposit — or CD — at one point or another. But, what exactly is a CD? How does it work, and how much return on investment can you expect from one, especially depending on the amount you put in?

Let’s learn more.

What Is a CD?

A certificate of deposit (CD) is a type of savings account where money is kept for a fixed amount of time, and during that time it earns a set amount of interest. The key here is the fixed amount of time since you can’t withdraw from it whenever you feel like it, in the same way you could with regular savings accounts.

The set amount of interest also means that you’ll know exactly how much you’ll earn by the end of the period. If you want to take out money from your CD before your agreed-upon term is up, then you’ll likely have to pay an early withdrawal penalty.

How to calculate the return of a CD

The return on a certificate of deposit depends on several key factors:

• the dollar amount of your initial deposit
• time duration (or term of the certificate of deposit)
• interest rate
• compound frequency

In more complicated examples one needs to add things like regular contributions and the tax rate at which interest is taxed in your jurisdiction.

One of the easiest ways to figure out your return on a CD is to use a CD calculator which takes in all of the above information and does the compounding interest math for you. The calculator will give you helpful insights like the amount of interest accrued (this is your gross return), capital growth (both nominal and adjusted for inflation), the amount of interest after taxes (net return). In some advanced tools you can enter the expected or actual interest rate and they will return an inflation-adjusted value.

Our CD calculator handles periodic contributions, tax on the interest accrued for gross and net return, and inflation adjusted returns. This way you can get a clear picture of how your current investment is doing or how a prospective one might perform.

Example calculations of the return on a certificate of deposit

If I put $500 in a CD…

Let’s imagine you’re considering opening up a short-term CD with a six-month term and 1% interest rate that compounds monthly. If you were to put $500 in that account, you would accrue $2.51 in interest, bringing your deposit value after six months to $502.51.

Now let’s see how much things change if you decide to go with a long-term deposit instead. In this scenario, imagine that your long-term CD has a five-year term and 4% interest rate. Putting $500 into that CD means that at the end of your term, you’ll have earned $110.50 in interest, bringing your deposit value to $610.50.

If I put $1,000 in a CD…

Using the same interest rates and terms as examples, how much money could you make if you decide to double your deposit to $1,000? If you put $1,000 in the same kind of short-term deposit we mentioned previously, you would accrue $5.01 and raise your deposit value to $1,005.01 after the six months were up.

Putting $1,000 into a long-term CD like the one discussed above brings your interest accrued up to $221 and your deposit value to $1,221 after five years partially due to compounding interest.  

If I put $10,000 in a CD…

Thinking of investing in the five-figure range? As one last example, let’s consider what happens if you raise the initial deposit to $10,000. With the short-term CD, your interest comes out to $50.10 and your deposit value after the term is complete to $10,050.10. 

With the long-term CD, your interest accrued would be $2,209.97 and your deposit value after five years would be $12,209.97. As you can see from the examples, it can really pay off to deposit more money when creating your account and to let your money sit in there for longer.

Certificate of deposit compared to other investments

On one hand, CDs are considered a safer investment opportunity and the low risk they carry means they earn comparatively low returns. Stocks, mutual funds, peer-to-peer lending, and certain bonds can all potentially offer you a higher return if you’re willing to take that higher risk with them.

On the other hand, when compared to a traditional savings account, certificates of deposits generally come with higher interest rates. Typically, the longer the term you agree to or the higher your deposit amount, the higher the interest rate you can get. In other words, if you go with a short-term CD, you’ll get access to your money sooner, but with a long-term CD, you’ll get a much better interest rate.

When evaluating investment returns with your CD, it’s worth it to look into several financial institutions so you can compare what kind of interest rates they’re offering for different deposit amounts and terms. That way you can figure out which arrangement will offer you the highest return on your CD investment.

There are other factors that affect what kind of interest rate you get for your CD, including the federal funds rate. When the federal funds rate is high or increasing, then it means that probably the CD interest rates are high or are increasing too.

Important conditions to be aware of

The Lock-in Period

One of the most important things to understand about a CD is the lock-in period, otherwise known at the duration of the deposit. This is a critical factor in determining what the return on a CD investment will be. As mentioned earlier, longer lock-in periods usually result in higher absolute returns. However, the downside to longer lock-in periods is that it exposes investors to inflation risks. As inflation erodes the purchasing power of money, the interest earned on a CD may not be sufficient to keep up with inflation. This means that the longer the lock-in period, the more significant the inflation risk.

Investors should therefore carefully evaluate their financial goals and risk tolerance when selecting the duration of their investment. If they need quick access to their funds or are concerned about inflation, they may prefer to invest in shorter-term CDs. (And, also keep in mind that the early withdrawal penalty, which is usually a period’s worth of interest ranging from 90 days to 18 months, depending on the financial institution.) On the other hand, if they can tolerate a higher degree of risk and want to maximize their returns, they may choose to invest in longer-term CDs.

It’s also worth noting that some financial institutions offer special deposits with higher interest rates or more flexible terms, which may be worth considering. However, it’s necessary to read the fine print and understand all the terms and conditions before investing in any CD, and/or working with a financial advisor who can help.

Certificate of Deposit’s Minimum Balance

The minimum balance required for a certificate of deposit depends on which bank or credit union you’re using. Generally, this minimum balance ranges between $500 to $1,000. That being said, there are some banks that don’t have any minimum balance requirements at all, and there’s such a thing as a jumbo CD, which requires a much higher minimum deposit (typically $100,000). 

Deciding on how much you want to put in your CD is important because most of the time you can’t add any more money inside after that initial point until the account reaches maturity. If you have more money you want to set aside in a CD, you can always open additional ones.

Summing It All Up

CDs are just one of many different options if you’re looking to invest your money. To compare CDs with different interest rates and terms from different financial institutions, you can use a CD calculator to quickly and easily figure out exactly how much money you’ll accrue when your account matures. In jurisdictions with non-zero tax rate on interest, net return should be the primary measure as opposed to gross return.