Power of compounding boosts CD yields

Dear Dr. Don,
If I buy a $1,000, five-year CD at 4 percent annual percentage yield, does that mean I earn $40 a year or $200 after five years? Or, am I misunderstanding something?
-- Phil Pickup

Dear Phil,
You almost have it. What you're doing is calculating the total interest as simple interest where there's no compounding. Your way only works if the interest is paid out to you and not reinvested over time. A CD that doesn't pay out the interest allows interest to earn interest after it's paid, increasing the terminal value of the investment.

A CD that pays 4 percent APY earns $40 the first year, but in the second year there's $1,040 on deposit so that money earns $41.60 in interest. The $1,081.60 on deposit for year three earns $43.36 in interest, etc.

You can use Bankrate's Certificate of deposit calculator to find out the value of a CD over time base on its nominal, stated, interest rate, frequency of compounding, and deposit term. The calculator will solve for APY based on these parameters.