- 1). Find the Annual Percentage Yield for your CD, fund or any investment that accrues interest. For this example,assume you are calculating the rate of return on a $1,000 certificate of deposit that has an APY of 4 percent. Use the letter r to represent the interest, and write this as r = 0.04, converting 4 percent into a decimal.
- 2). Multiply the initial investment by the interest rate. Here's an easy way to do the math: add a 1 to the percentage (expressed as a decimal) to turn it into a multiplier. Using the interest rate (r) for the CD you get 1 + 0.04 = 1.04. Now you can find how much interest accrues from the nominal rate like this:
$1,000 x 1.04 = $1,040.
You have earned $40 on our initial $1,000 at an interest rate of 4 percent. - 3). Estimate the time frame to calculate. Is the interest compounded on a monthly schedule, quarterly, yearly? You can find this information in your disclosure statement. Call this the compounding period or frequency and use the letter n to represent it. The interest on the example CD has a monthly compound rate of 4 percent, so write n = 12. If your rate compounds quarterly, use the number 4; once per year equals a 1, and so on.
- 4). Add the interest rate over a period of time to see how compounding works. Using the CD with a 4 percent nominal rate, you can use simple math to watch it grow:
$1,000 x 1.04 = $1,040 (earned $40)
$1,040 x 1.04 = $1,081 (earned $81)
$1,081 x 1.04 = $1,124 (earned $124)
Notice that you multiply each new balance by 1.04. Over time, this compounding has a powerful effect. But you can take a another short cut and calculate the compounded total by using the power of 12 to represent 12 months:
$1,000 x 1.04^12 = $1,601.03 - 5). Calculate the compounded rate of return, also known as the effective annual rate, the APY and the periodic compounded rate. Using the same CD as an example, replace the letter r with the nominal rate and the letter n with the frequency. The complete formula is:
Effective Annual Rate = [1 + (r/n) ^n] - 1
1000 x [1+(0.04/12) ^12] -1 = 1,040.7
Remove the 1 to convert it to a percentage and you have an effective interest rate of 4.07 percent.
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