What happens when a CD is reinvested with its accumulated interest?

What happens when a CD is reinvested with its accumulated interest?

• A. The ultimate yield is higher than the stated rate of interest.
• B. The yield remains the same as the stated rate.
• C. It declines due to compounding.
• D. It is taxed as income immediately.

Answer: (A)

Reinvesting the accumulated interest creates compounding. When interest earnings are added to the principal, the next round of interest is calculated on a larger amount, so the overall return grows beyond the original stated rate. In other words, the total yield you achieve becomes higher than the nominal rate because you’re earning interest on interest. The impact is that the CD’s effective yield exceeds the stated rate over the term. The idea doesn’t fit the other options because compounding does not keep the yield the same, nor does it reduce it; taxes may apply, but they don’t negate the fact that reinvested interest increases overall yield.

Reinvesting the accumulated interest creates compounding. When interest earnings are added to the principal, the next round of interest is calculated on a larger amount, so the overall return grows beyond the original stated rate. In other words, the total yield you achieve becomes higher than the nominal rate because you’re earning interest on interest. The impact is that the CD’s effective yield exceeds the stated rate over the term. The idea doesn’t fit the other options because compounding does not keep the yield the same, nor does it reduce it; taxes may apply, but they don’t negate the fact that reinvested interest increases overall yield.