Certificates of deposit -- CDs, for short -- are a type of time deposit you can invest in to earn interest. With a CD, you give the bank an initial deposit and earn interest income as the bank holds your cash. The amount of time the bank holds your funds is referred to as the CD's term, such as six months, 12 months or 24 months. How much interest you earn on a CD depends on the size of your initial deposit, the term, the annual percentage interest rate you're offered and how often the bank compounds your interest.
Annual Compounding Interest
Some banks compound interest once a year. That means after one year, the interest you've earned is reinvested into the principal of the CD, and you start earning interest on that as well.
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For example, say you purchase a $1,000 CD with a 1 percent interest rate that compounds annually. You'll earn 1 percent of $1,000 -- or $10 -- for the first 12 months. The interest earned on a six-month CD would be half of 1 percent, or $5. If you choose a 24-month CD, your new principal balance after 12 months is $1,010, and you'll earn 1 percent on that for the second 12 months, which would be $10.10. That means the total interest earned on a 24-month CD would be $10 plus $10.10, or $20.10.
Daily Compounding Interest
As an incentive, some banks offer to compound your CD interest on a daily basis. That means the interest you earn is reinvested into your CD principal every day. This is a good thing for you; you'll earn more interest on your CD.
To calculate how much interest you'll earn when interest compounds daily, you convert your annual percentage rate into annual percentage yield. Annual percentage yield is an effective interest rate that accounts for how often the interest is being compounded.
The formula for APY is (1 + r/n)n - 1, where r is your annual interest rate and n is the number of times during the year that the interest is compounded. If your annual interest rate is 1 percent and your interest is compounded 365 times during the year, your APY equals 1.005 percent. The interest you'll earn on a $1,000 six-month CD would be half of 1.005 percent, or $5.03. The interest earned on a 12-month CD is $1,000 multiplied by 1.005 percent -- 1,000 x 0.01005 -- or $10.05. Your total for a 24-month CD is $10.05 for the first 12 months and $10.15 for the second 12 months, for a total interest of $20.20.