Basic Principles
A certificate of deposit is a form on investment where a person contributes a certain level of money with a pre-determined interest rate and maturity. For example, a person may deposit $5,000 for a 6-month CD at a 4 percent interest rate. Investing in a CD is generally considered to be safer than other investment forms, such as the stock market. In some ways, a CD acts as a savings account---however, you cannot withdraw the funds without penalty until they have matured. Some CDs take upwards of 5 years to reach their maturity, meaning investing in a CD can mean a major time investment.
Banks and Interest Rates
Once a person contributes their funds, the bank takes these funds and is able to loan them to others or reinvest them in other moneymaking ventures. The bank is able to offer the money at a higher rate because it can rely on the funds to be in the bank for a set period of time, unlike a checking or savings account, where funds can be removed without prior notice. Ideally for the bank, they will be able to make more money on using the contributor's funds than when they pay the contributor a higher interest yield for the CD.
Calculating Interest
A contributor can either opt to withdraw the funds early (which is subject to penalties and fees) or allow the funds to mature to reach the agreed-upon interest rate, which can either be a fixed or variable (fluctuating) interest rate. The annual interest rate is calculated using the formula Investment * Percentage/12 * Term of CD = Annual Interest Yield. For example, if you have purchased a CD with a $5,000 investment that yields 6% over a term of 5 years, the bank will use the following formula to calculate the interest rate: $5,000 X .06/12 = $25 interest earned for the year. Therefore, in five years, a person will earn $125 total. However, if the interest is compounded (meaning each year builds upon the next), the investment should be recalculated every year.
Another formula that can be used should your interest be earned on a daily (not monthly) basis is Investment * Percentage/365 * Number of Days in Term = Annual Interest Yield. This formula will allow you to calculate interest earned on your CD investment to date.
After your CD has reached its length of time for maturity value, the bank pays the final value on the interest earned on the CD, and it is withdrawn from the bank. Leaving the money in the fund typically does not earn any more funds and may actually be subject to penalties and fees.
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