Maximizing Your Earnings: Understanding APY on a CD

Defining Annual Percentage Yield (APY)

When it comes to putting money into a savings account, such as a certificate of deposit (CD) or a high-yield savings account, the metric to focus on is the annual percentage yield (APY). Also known as the effective annual rate, it is a measure of the compound interest you can expect to receive over a one-year period on your monetary deposit.

Compound interest is a term that describes the accumulation of interest on previously earned interest, as well as on the initial amount invested. This differs from simple interest, which only accrues on the initial investment.

Compounding frequency refers to the number of times per year that interest is regularly computed and accumulated. The greater the frequency, the faster interest income will accumulate.

Incidentally, the interest on most savings vehicles is compounded either daily, monthly, quarterly, semiannually or annually. For CDs, the standard is daily compounding.

How Does Annual Percentage Yield Work?

The APY metric offers a clear indication of the total interest income a savings vehicle offers on an annual basis. It is a more comprehensive metric than the simple interest rate, also referred to as nominal interest, because it reflects the effect of interest compounding on interest. The best way to explain how APY works is with a numeric example.

So, assume you’ve made a $25,000 investment in a three-year CD, offering a simple annual interest rate of 5% with daily compounding (365 days in a year). The APY is as follows:

APY = (1 + Simple Annual Interest Rate ÷ Compounding Periods) ^ Compounding Periods – 1

APY = (1 + 0.05000 ÷ 365) ^ 365 – 1 = 0.05127 or 5.127%

Then, you can calculate the value of the CD at the end of each year as noted below. The year-over-year growth represents the interest income earned each year.

Ending Year Value = Beginning Year Value × (1 + APY)

Therefore, the following shows how much interest you would accumulate per year with your initial investment of $25,000.

Ending Year 1 Value = $25,000.00 × (1.05127) = $26,281.75

Ending Year 2 Value = $26,281.75 × (1.05127) = $27,629.22

Ending Year 3 Value = $27,629.22 × (1.05127) = $29,045.77

Alternatively, you can jump to the maturity date and calculate the ending value of the CD as follows:

Ending Year 3 Value = Initial Investment × (1 + APY) ^ (Months Until Maturity ÷ 12)

Ending CD Value = $25,000.00 × (1 + 0.05127) ^ (36 ÷ 12) = $29,045.77

The difference between the initial investment, $25,000, and the ending balance, $29,045.77, is the interest income earned over the life of the CD, which amounts to $4,045.77. On an annual basis, this amount will accumulate at a rate of 5.127%, the annual percentage yield (APY).

Average APY on Certificates of Deposit

Based on information compiled by the Federal Deposit Insurance Corporation (FDIC) from March 2023, the national average APY offered on a 12-month CD is 1.49%. This reflects the deposit-weighted average of all 12-month CDs paid by all insured banks and credit unions as of the date listed.

The FDIC’s rates page is a good resource to gauge whether a CD rate is competitive, but matching the national average is not advisable. This is because the best available CD rates are consistently about five times higher than the national average.

Factors That Affect APY on a CD

The APY on a CD is largely influenced by the Federal Reserve’s monetary policy positioning and the current level of the federal funds rate, which is the overnight lending rate for commercial banks.

Essentially, as the Fed increases or decreases the federal funds rate, the banks and credit unions react by moving their CD rates in the same direction. That said, the moves are not always proportionate; deviations reflect competitive endeavors to establish distinct positions.

Beyond the foundational influence of the federal funds rate, the APY on a CD is impacted by a handful of other factors.

Other Factors That Impact APY

• The longer the CD term (time until maturity), the higher the interest rate. Normally, the risk of locking up your money for longer periods yields greater compensation.
• The more money deposited in a CD, the higher the interest rate. This is most discernible when evaluating the APYs offered on normal CDs and jumbo CDs.
• Traditionally, structured CDs, which have early withdrawal penalties, offer higher yields than free withdrawal, no-penalty CDs. Essentially, this is because no-penalty CDs shift risk from the investor to the CD issuer. This aligns with the core investing principle of return versus risk, whereby higher returns entail higher risk.

How To Find the Best APY on a Certificate of Deposit

You can search for the best APYs available through reputable financial news sources.

Generally, the highest CD rates you will ever see are comparable to the rate of inflation. Higher yields are rare and should be viewed with some skepticism. They are possible, but they call for additional due diligence.