When opening a certificate of deposit (CD) account, you'll likely want to consider the length of time you'll be depositing your money, known as the CD term. But did you know that the CD term you choose may also affect the CD return rate — or the amount you may earn — on deposited funds? Let’s explore what CD terms are, how they relate to return rates and how compound interest can affect your CD's real rate of return.
How CD terms affect rates
A CD’s term period can vary, with common options including 1-year, 2-year, 3-year, 5-year, 10-year or even longer-term periods. Note that CD terms may also be expressed in the number of months, rather than years.
An important consideration when opening an account is the CD return rate — the amount a certificate of deposit may pay on deposited funds. The relationship between CD terms and CD return rates is often inversely proportional, meaning that as the term period increases, the return rate on the CD also increases. In other words, the longer the CD term, the higher the CD’s possible return rate.
How compound interest works
Compound interest is, essentially, interest earned on previously accrued interest. Compound interest occurs when the interest earned on a deposit is added back to the principal and interest is then earned on the new, larger principal. This process is repeated, compounding the interest over time, leading to a higher overall return on the investment than a flat interest rate alone. This concept is important to understand, as many CDs utilize compound interest.
Tools like a CD rate of return calculator may help better understand how compound interest can affect your CD’s real rate of return over time, factoring in your initial deposit, term period, CD rate and compounding frequency.
Assessing your CD’s real rate of return
Another tool for understanding the returns you can expect from a CD is the annual percentage yield (APY) of the account. APY measures returns similar to interest rates, but it takes it further by considering compounding frequency. This is important because two accounts with the same interest rate, compounded at different frequencies, produce two different rates of return. The more often interest compounds, the more often your principal grows and the more interest you accrue over time.
Considering your CD term period alongside its APY may help paint a clearer picture of your potential returns. The term period dictates the length of time and number of times your interest will compound, helping to clarify how your principal could potentially grow.
When opening a CD account, CD term and the CD return rate are often worthwhile considerations. The longer the term, the higher the return rate tends to be, but it’s important to consider the effect of compound interest on your real rate of return. By understanding the relationship between CD terms and return rates, and by using a CD rate of return calculator, you can make a more informed decision about which CD account may be right for you.