How Does the Interest Work On a 6 Month Certificate of Deposit?
Are you interested in how banks calculate the interest in certificates of deposit? Read to find out just how a certificate of deposit and interest work.
Certificates of deposit are like special savings accounts. The reason people go into them is because they are much safer than the stock market (most certificates are insured up to $250,000 just like bank accounts), and are also more lucrative than a regular bank account. Although times aren’t always great, you are much more likely to find a high interest rate in a certificate of deposit than in a regular savings account. The main downside is that it isn’t as easy to get your money out of a certificate of deposit in most cases, so you’ll want to be sure you don’t need the money before it matures.
Interest on a 6 Month Certificate of Deposit
In order to better understand how a certificate of deposit works, let’s look at a hypothetical example of a certificate. Say you’ve found a certificate of deposit that matures in six months. It wants you to put in a minimum of $1000, and you put in $1250. The interest rates are a respectable 2.5% when you sign up. In order to figure out how much you’ll get per month, you’ll want to use this formula:
(Balance x Interest Rate) / 12
For this example, take $1250 x .025 = $31.25
Then, divide $31.25 by 12 = $2.604
The answer is $2.604 per month.
What About Compound Interest?
But in order to really understand how the interest works on a 6 month certificate of deposit, you have to take compounding interest into account. What’s been calculated so far is how much money you would get per month if you had 2.5% interest on $1250, but keep in mind that most certificates reinvest those dividends. Therefore, 3 months in, you would have $2.604 x 3 added on to the certificate of deposit, or $1257.81. What would happen if the certificate of deposit looked at the new balance each time you reinvested your dividends and calculated the interest based on that? You’d have an Annual Percentage Yield that was compounded monthly. Therefore, the APY will be higher than the APR.
Taken in the same example, you would want to calculate the 2.5% after the first month had added $2.604 to the total balance. You would take $1252.604 x .025 = $31.315. Then, divided by 12 = $2.609. Each month, the interest rate will take a higher balance into consideration, meaning your total yield over a year will be higher than the dividend rate.
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