The Calculation of APY
One common misconception is that when you buy a CD, you will receive the full APY (annual percentage yield). However, APY is calculated on an annual basis. Let’s say you see a 6-month or 9-month CD with a quoted 5% APY. It’s important to understand that you won’t receive the full 5%. The rate you actually earn will be equivalent to that percentage for the amount of time you hold the CD. For instance, a 6-month CD at 5% APY would yield half of the total percentage.
Greg McBride, chief financial analyst at Bankrate, provides a simple example to illustrate this concept. If you invest $1,000 in a CD with a 5% APY, the amount of interest earnings will vary depending on the CD’s maturity period. With a 1-year CD at 5% APY, you would earn $50 in interest. Meanwhile, a 9-month CD would earn you $37.28, and a 6-month CD would only yield $24.70 at 5% APY.
Comparing CD Rates
So, how does APY impact your decision when choosing between different CD terms? Essentially, APY enables you to make an apples-to-apples comparison of rates. It allows you to determine which CD pays the highest interest on an annual basis and simplifies the decision-making process.
Understanding these basics about CDs will help you navigate the world of certificate of deposit offers more effectively. Remember to consider the length of the CD term and how it relates to the APY when making your investment decisions.
CDs and Taxes
Uncle Sam is going to come after your CD earnings. Interest received on CDs, if it’s above $10, is taxed as ordinary income.
According to financial planner Alex Doyle at Woodson Wealth Management, if someone is in the 25% tax bracket and earns $500 in interest from a CD, they would owe $125 in taxes on that interest income. Furthermore, McBride points out that in the top tax bracket of 37%, you net just 63 cents of every dollar of interest after accounting for taxes.
In addition to federal income tax, CDs are also subject to state income tax. If you want to find tax-smart ways to deal with your CDs, Picks has a helpful guide.
CDs and Penalties
Another factor that can eat into your CD earnings are early withdrawal penalties. However, avoiding these fees is simple: just stick with the CD until the maturity date specified in the terms.
Early withdrawal penalties often charge a percentage of earned interest. This means you may be charged a few months’ worth of interest or more if you withdraw the money early. Make sure to read the fine print on your CD to understand the potential charges.
It’s worth noting that certain CDs, like no-penalty CDs, may not have early withdrawal penalties, but they do come with other downsides. You can learn more about them in this Picks guide.
Other Considerations
When considering CDs, it’s important to take into account whether intermediate and longer-term interest rates are expected to remain lower than shorter-term rates. According to certified financial planner Bruce Primeau at Summit Wealth Advocates, short-term CD rates may be substantially lower than long-term rates in the future. Therefore, it might be more beneficial to lock in a slightly lower long-term rate rather than a higher rate for a shorter period of time.
