The annual percentage yield (APY) on a certificate of deposit (CD) is the amount of interest you will earn each year. The APY is normally expressed as a percentage, so you might see a CD advertised as having a 1% APY. In this case, if you have $100 in the CD, after a year, you will have earned an extra 1% (so you’ll have $101).
APY is the most common measurement of the returns offered by a CD because it takes everything into account—both the raw interest rate you are paid for your CD, plus the effect of compounding. If you are looking for the CD with the best rate, you should look primarily at the APY it offers.
In this article, we’ll explain what APY is and how you can use it to find the best CD for you.
Key Takeaways
- The annual percentage yield (APY) of a certificate of deposit (CD) is the amount of interest that a CD pays in a year.
- If a CD pays 1% APY and you deposit $100, you will have $101 at the end of the first year.
- APY is a useful measure of CD returns because it factors in the effect of compound interest.
- When researching CDs, look for the highest APY for your desired length of investment term.
- Be sure to understand any penalties associated with early withdrawal.
Understanding Annual Percentage Yield (APY)
The annual percentage yield (APY) is the real rate of return earned on an investment, taking into account the effect of compounding interest. Unlike simple interest, compounding interest is calculated periodically and the amount is immediately added to the balance. With each period going forward, the account balance gets a little bigger, so the interest paid on the balance gets bigger as well.
The rate of return for certificates of deposit (CDs) is generally quoted as the APY. That’s for several reasons. CDs pay compound interest either monthly or even daily, and so to work out the return on them after a year, you would have to perform a complicated calculation.
It’s important to note that compounding only occurs if the owner doesn’t withdraw the interest in the CD. Some CDs allow for depositing dividends to another account as they’re accrued and if this option is chosen, the benefits of compounding are lost and the full APY on the CD is not received.
The APY quoted for a CD already takes into account the effect of compounding whether it’s monthly or daily. So if you see a CD that compounds monthly and has an advertised APY of 1%, the actual amount of interest paid per month will be carefully calculated by your provider so that at the end of the year, you’ve made exactly 1%.
This makes comparing CDs much easier because customers don’t have to calculate annual yields themselves. It also allows the bank to quote a more impressive percentage return (1% APY rather than 0.08% monthly, for example). It can be a little confusing, however, when you get a statement for your CD and see that the interest rate you are receiving is less than the advertised one. If you run through the math, you’ll probably see that the difference is due to compounding. If it’s not, you should contact your CD provider.
CDs pay compound interest. The interest you earn on your deposit is added to your account balance each day or month, and your next interest payment is based on this new account balance. Calculating compound interest can be tricky, but the APY rate already takes into account the effect of compounding.
Finding the Best APY on a CD
The APY offered by a CD is arguably its most important feature. Nowadays, you can take out a CD with hundreds of banks across the country, and the APY they pay varies widely. The top nationally available CD rates are typically three to five times higher than the industry average for every term, so shopping around can deliver significant gains. In general, a bank or credit union will pay you a higher APY for CDs that have longer terms or require a higher initial deposit.
In general, the APY will tell you all you need to know about the returns you’ll receive from a CD, and therefore, how it compares to others on the market. The only extra factor you’ll normally have to consider is the early withdrawal penalties a bank will charge. These vary between CD accounts, and there are even types of CD without penalties. If you are taking out a CD, you should expect to leave your money in the account for the entire term, but if you suspect you might need the money in an emergency, you should make sure you understand the penalties associated with accessing it early.
How Much Does a $10,000 CD Make in a Year?
It depends on the APY. For example, a $10,000 deposit in a five-year CD with 1.50% APY would earn around $770 in interest, while the same deposit in a five-year CD with 0.01% APY would earn only $5 in interest.
What Does 5% APY Mean?
This means a CD (or another kind of account) that pays 5% in returns annually. If you deposit $1,000 into a savings account that pays 5% simple interest annually, you will have $1,050 at the end of the year. However, the bank may calculate and pay interest every month, in which case you would end the year with $1,051.16. In the latter case, you would have earned an APY of more than 5%.
What Is a Good APY?
The national average savings rate is 0.06% APY, but you can find CDs with APYs higher than this. A good one-year CD might pay an APY of 1.5%, and a good five-year CD may pay 2.5%.
The Bottom Line
The annual percentage yield (APY) of a certificate of deposit (CD) is the amount of interest that a CD pays in a year. If a CD pays 1% APY and you deposit $100 in it, for example, you will have $101 at the end of the first year.
APY is a useful measure of CD returns because it takes into account the effect of compound interest. When you are looking for a CD, you should look for the account with the highest APY for your desired length of the investment term. Just make sure you also understand the early withdrawal penalties associated with the CD account you choose.