On this week’s Money Matters Monday, we tackle a financial topic that often gets overlooked: Certificates of Deposit, or CDs. 

A viewer, Jan, sent in a question asking: “If I do a six-month CD at 4.3% APY with compounding interest, would it pay out the same dollar amount as a six-month promotional CD at 4.3% APY with interest paid at maturity?” Barry explains that while both CDs may have the same APY, they can work very differently when it comes to how interest is added to the account.

Barry breaks it down, “A CD is a timed deposit. The bank sets the terms on how often it will add interest and how long you must keep your money in the account. If you take the money out early, you could incur penalties, so it’s important to know what you’re getting into before locking your funds away.”

But what about APY? Barry explains, “APY stands for Annual Percentage Yield, and it lets you compare different CDs on equal terms. Even if one CD has a higher interest rate, it could have a lower APY depending on how frequently interest is compounded.”

This brings us back to Jan’s question. Barry shows that the two different CDs may have the same APY of 4.3%, but one compounds interest more frequently than the other, which leads to the same yield at the end. “In one case, the CD compounds more often, but has a lower interest rate. In the other, the interest is added only at maturity, but the rate stays the same.”

So, why are CDs important for long-term savings? Barry highlights that banks use CDs as a way to fund loans, “If you lock your money in a five-year CD, the bank can take that money and lend it out on things like car loans. They make money by charging higher rates on the loans than the rate they pay on your CD.”

Bigelow compares the concept to mortgages, “The same concept works for mortgages, where interest accrues daily. If you make an extra payment early in the month, you can reduce the principal, thus lowering the interest charged later in the month.”

“It’s all about knowing the details and using the system to your advantage,” Barry says. So, for those looking to make smart decisions about their money, understanding CDs, APY, and interest compounding is key.

Have a burning financial question? Send it our way! Barry will be back next week to help answer more of your questions. Don’t forget to email us or reach out via our Facebook page!