The basic formula: principal, rate, and time

A certificate of deposit earns interest using a straightforward calculation: the bank multiplies your deposit amount by the interest rate and the length of time your money stays in the account. The formula is Interest = Principal × Annual Rate × Time (in years). If you deposit $10,000 at 5% annual interest for one year, you earn $500. If you keep it for six months instead, you earn $250.

The interest rate advertised by the bank is always an annual percentage rate, even if your CD matures in three months or five years. The bank converts that annual rate to match your actual holding period. This is why a CD with a higher rate always produces more interest than one with a lower rate, all else equal.

Key Takeaways

  • Interest on a CD is calculated by multiplying your deposit amount by the annual interest rate by the fraction of the year you hold the money.
  • Most banks use simple interest, not compound interest, so your interest does not earn interest during the CD term.
  • The stated rate is always annual, even for CDs that mature in weeks or months; the bank divides it by 12 or 365 to match your term.
  • Some banks calculate interest daily and credit it monthly or at maturity, while others use a 360-day year instead of 365, which slightly reduces your earnings.
  • You can compare CDs fairly by looking at the annual percentage yield (APY), which accounts for both the rate and how often interest is compounded.

Simple interest versus compound interest

Most banks use simple interest on CDs, meaning your interest does not earn interest. The bank calculates what you owe once, at maturity, and pays it all at once. A $10,000 CD at 5% for two years earns $1,000 total—$500 in year one and $500 in year two, not $500 plus interest on that $500.

A few banks offer CDs with compound interest, where interest is credited to your account monthly or quarterly, and then earns interest itself in the remaining months. This produces slightly more money at maturity, but the difference is small on most CDs. For example, $10,000 at 5% compounded monthly for one year earns about $512 instead of $500—a difference of $12. Compounding matters more on longer terms and higher rates.

When you see the term annual percentage yield (APY), that number already includes the effect of compounding. The APY is always equal to or higher than the stated rate. If a CD shows a 5% rate and 5.13% APY, the difference reflects monthly compounding.

How banks handle different term lengths

A CD's term can be three months, six months, one year, three years, or longer. The bank divides the annual rate by the number of periods in a year to calculate interest for shorter terms. A CD with a 4% annual rate held for three months earns 1% (4% ÷ 4 quarters). A six-month CD at 4% earns 2% (4% ÷ 2 half-years).

The calculation is the same whether you hold the money for 90 days or 1,095 days: the bank converts the annual rate to your actual holding period and multiplies by your principal. This is why comparing CDs requires looking at the annual rate, not the total interest paid. A three-month CD at 5% and a one-year CD at 4% are not directly comparable without doing the math yourself.

The difference between 365-day and 360-day years

Most banks calculate daily interest using a 365-day year, but some use a 360-day year (called the "ordinary interest" method). Using 360 days instead of 365 slightly increases the daily rate and produces slightly more interest. However, the difference is small—on a $10,000 CD at 5% for one year, using 360 days instead of 365 adds about $0.68.

Banks disclose which method they use in the CD's terms and conditions, but it is rarely the deciding factor when comparing CDs. The stated annual rate matters far more than the day-count method. If one bank offers 5% with a 360-day year and another offers 4.9% with a 365-day year, the first CD will pay more.

When interest is credited and paid

Banks calculate interest daily but do not always credit it to your account daily. Some credit interest monthly, others quarterly, and some only at maturity. The timing of when you receive the money does not change the total amount you earn—only the annual rate and term length matter.

If you withdraw your CD before maturity, the bank usually stops calculating interest on the withdrawal date. Some banks credit interest through the last day of the month in which you withdraw; others stop on the exact withdrawal date. This is another detail in the terms and conditions that rarely changes the outcome significantly.

How to calculate your own interest

You can verify a bank's calculation using the simple interest formula. Multiply your principal by the annual rate by the time in years. For a $5,000 CD at 4.5% for 18 months: $5,000 × 0.045 × 1.5 = $337.50. If the bank shows a different amount, check whether they are using compound interest (which would be slightly higher) or whether you misread the rate.

For compound interest, the math is more complex, but the bank's disclosure should show the APY. Multiply your principal by (1 + APY) raised to the power of the number of years, then subtract the principal. For $5,000 at 4.5% APY for one year: ($5,000 × 1.045) − $5,000 = $225. Most banks show the projected interest in the account opening documents, so you do not need to calculate it yourself.

Why rates vary between banks and terms

Different banks offer different rates because they have different funding costs and different strategies. A bank that needs deposits urgently may offer higher rates. A bank with excess deposits may offer lower rates. Rates also vary by term: banks often offer higher rates for longer commitments because they can lend that money out for longer periods.

The rate you see advertised is the rate you will earn if you open the CD that day. Rates change daily, sometimes multiple times. A CD opened on Monday at 5% may have a different rate on Tuesday. Once you open the CD, your rate is locked in for the entire term, even if rates fall or rise later.

Frequently Asked Questions

Does my CD interest earn interest?

On most CDs, no—banks use simple interest, so your interest does not earn additional interest. Some banks offer compound interest CDs where interest is credited monthly or quarterly and then earns interest itself, but the difference is usually small. The APY shown in the disclosure accounts for any compounding.

What happens to my interest if I withdraw early?

You lose the interest you have not yet earned. If you withdraw after six months of a one-year CD, you receive your principal and the interest earned through the withdrawal date, but you forfeit the interest that would have been earned in the remaining six months. You may also pay an early withdrawal penalty.

Is the advertised rate the same as the APY?

Not always. The advertised rate is the annual interest rate. The APY is the annual percentage yield, which includes the effect of compounding. If interest is compounded, the APY will be slightly higher than the rate. For simple interest CDs, the rate and APY are the same.

Can the bank change my interest rate after I open the CD?

No. Once you open a CD, your rate is locked in for the entire term. The bank cannot lower your rate if market rates fall, and you cannot raise it if rates rise. This is one of the main features of a CD—the certainty of a fixed return.

How do I compare interest between a three-month and a one-year CD?

Convert both to annual rates. A three-month CD at 5% earns about 1.25% over three months. A one-year CD at 4% earns 4% over 12 months. The one-year CD pays more total interest if you hold the money for a full year, but the three-month CD lets you reinvest sooner if rates rise.