You’ve heard the term CD used among banking and financial professionals but aren’t quite sure what it means. In short, it’s an acronym for “certificate of deposit,” a type of savings account that offers a fixed interest rate for a specific term – often higher than what you’ll get with a traditional savings account. In exchange, you must agree to keep your money parked in the CD until the term expires.
This guide provides a breakdown of these savings vehicles, including how they work, key features to be aware of, benefits, risks, how to choose the best option and ways to maximize returns if you decide to open a CD.
What is a CD in Banking?
A Certificate of Deposit (CD) is a type of savings product offered by banks and credit unions. It allows you to deposit money for a fixed period in return for earning interest.
CDs from different financial institutions might have varying terms. Generally, the longer the term, the higher the interest rate you can expect.
They are also federally insured through the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Administration (NCUA). This means up to $250,000 of your deposit is protected if the bank or credit union fails.
Purpose and Use of CDs
Individuals primarily use a CD to save money and earn interest on it to build an emergency fund or cover big-ticket purchases. Others use CDs to help them meet other pressing short-, medium or long-term financial goals.
Key Features of Certificates of Deposit
CDs feature fixed terms and impressive APYs but often come with minimum deposit requirements and early withdrawal penalties.
Fixed Term Lengths
CDs come with fixed term lengths, which can range from a few months to several years. When you open a CD, you agree to lock your money away for this period.
The term is important because it affects the interest rate you earn. Shorter terms often have lower rates, while longer terms may offer higher rates.
Interest Rates
CDs usually provide a fixed interest rate over the term. This means the rate doesn’t change, no matter what happens with other interest rates in the market. This makes CDs a secure way to grow your savings because you know exactly how much interest you’ll earn.
Again, the fixed interest rate tends to be higher than what regular savings accounts offer. Some banks and credit unions extend higher APYs on CDs through special promotions to attract more deposits from both new and existing customers.
Minimum Deposit Requirements
When opening a CD, banks and credit unions often require a minimum deposit. This amount can vary widely between different banks and types of CDs. Sometimes, it might be as low as $500 or as high as several thousand dollars.
The minimum deposit can also affect your interest rate. Higher deposits might qualify you for better rates. Determine what you can comfortably afford to deposit without digging too deep into your reserves.
Early Withdrawal Penalties
CDs reward you with fixed returns, but there’s a catch. An early withdrawal penalty applies if you take money out before the term ends.
Penalties can vary based on the bank and CD term, often requiring a few months’ interest. Or you may lose a portion of your principal, depending on how much you withdraw.
How Certificates of Deposit Work
Below is an overview of what to expect when applying and managing a CD.
Account Opening Process
You can open a CD by applying online or at a physical branch (if available). Be sure to complete the application in its entirety and have the funds readily available to make the minimum opening deposit.
If you want to open a CD with a credit union, membership is required before moving forward.
Interest Calculation Methods
CDs typically use simple interest, which is computed based on the principal. It’s expressed as an annual percentage yield (APY) that includes compound interest that causes interest to grow on top of interest.
Maturity and Renewal Options
When your CD matures, you can pull the funds you invested and any interest earnings. Or you can roll the balance into a new CD. But if you choose not to notify the bank or credit union of your intentions, they may automatically roll the funds into a new CD for you.
Tax Implications
Interest earned from a CD is considered taxable income in the year it’s received. Even if you don’t withdraw the money, the accrued interest is still subject to taxes.
You will receive a Form 1099-INT from your financial institution detailing how much interest you have earned. This figure must be reported on your tax return.
Types of Certificates of Deposit
There are a variety of CD options available to help you meet your savings goals.
Traditional CDs
Traditional CDs are the most common option. You deposit a certain amount for a specific term and earn a fixed interest rate. The interest rate is typically higher than regular savings accounts.
Jumbo CDs
Jumbo CDs require a larger deposit, often $100,000 or more. These CDs might offer slightly higher interest rates due to the large deposit size. They are similar to traditional CDs but designed for those who can invest more considerable amounts.
No-Penalty CDs
No-penalty CDs allow you to withdraw funds before the maturity date without facing penalties. Although the rates might be lower, they offer flexibility if you need to access your funds before the term ends.
Bump-up CDs
Bump-up CDs provide an option to increase your interest rate if rates rise during the term. Typically, you can request a rate increase once. This feature is beneficial when you expect interest rates to rise.
Step-up CDs
Step-up CDs automatically increase your interest rate at set intervals. For example, rates may rise annually during the term. Unlike Bump-up CDs, you don’t request increases; they are scheduled.
Brokered CDs
Brokered CDs are sold by brokerage firms instead of banks. These CDs generally offer higher rates and more terms to choose from. They are traded like bonds so that you can buy and sell them before maturity.
Liquid CDs
Liquid CDs allow you to withdraw some of your money without penalties, usually during specified periods. They balance the ability to earn greater returns than regular savings accounts with more flexibility than you’ll get with a traditional CD.
Benefits of Investing in CDs
There are several upsides to investing your hard-earned funds using a CD.
Stability and Security
When you invest in a CD, you lock in a fixed interest rate for the term of the deposit. This shields you from fluctuations that can affect other types of investments like stocks or mutual funds. Plus, a sizable amount of your funds are federally insured for added protection.
Predictable Returns
Most CDs offer fixed interest rates, meaning your return is unaffected by market changes. This consistency makes CDs an appealing choice if you prefer straightforward investment income. And you’ll know exactly how much interest you’ll earn over the CD’s term, assuming you steer clear of early withdrawals.
FDIC Insurance
As previously mentioned, funds in CDs held at FDIC or NCUA-backed entities are protected. The coverage is for up to $250,000 per depositor per bank.
Diversification of Investment Portfolio
CDs can be used to balance riskier investments and minimize the impact of market volatility on your portfolio. They complement stocks, bonds and other assets by providing stability and shielding your investments from the potential effects of significant market shifts.
Risks and Considerations
As with any investment product, there are also potential drawbacks to consider.
Inflation Risk
Inflation risk arises when the inflation rate surpasses your CD’s interest rate. Your purchasing power can decrease, making your money worth less when you withdraw it. So, despite the safety that CDs offer, the APYs they come with might not keep pace with rising prices.
Opportunity Cost
If interest rates rise after you open a CD, newer CDs might have better rates. In this case, you’d forfeit potential interest earnings by locking away your funds in your current CD until the maturity date. And if you did choose to pull money early to capitalize on rising interest rates, the early withdrawal penalty may be rather costly and exceed the benefit of doing so.
Interest Rate Fluctuations
Interest rate changes affect your CD only at renewal. If rates increase, the fixed rate of your current CD won’t take advantage. Conversely, if rates drop, you’re protected during your CD term. There’s no way to time the market, though, so this is somewhat of an inherent risk that comes with parking your funds in CDs.
Penalties for Early Withdrawal
You could lose a few months of interest or a portion of your principal if you withdraw money from a CD before it matures. These penalties are intended to discourage you from pulling funds prematurely.
How to Choose the Right CD
If you’re ready to open a new CD, keep these factors in mind when researching your options.
Assessing Financial Goals
Are you saving for a short-term need or a long-term objective? If you’re planning for a future purchase, a short-term CD with a lower interest rate might be better. For long-term goals, a CD with a longer term might offer better interest rates, as you’ll give your investment more time to grow.
Comparing Rates and Terms
APYs vary between financial institutions. Ideally, you want the highest APY for maximum returns. But you also want to keep the terms in mind – a longer term typically offers a better rate, but you’ll forfeit liquidity.
Evaluating Institution Reputation
Check the bank or credit union’s ratings and reviews to get a feel for their reputation and level of service provided. You can also speak to friends who bank with the entities you’re considering to garner additional feedback.
Understanding the Fine Print
Always read the fine print before opening a CD. Understand the penalties for early withdrawal, as these can significantly impact your earnings if you need to access funds before the term ends.
Also, watch for any fees that might reduce your overall returns. Some CDs also offer special features like the ability to add funds or “bump up” rates.
Strategies for Maximizing CD Returns
These strategies will help you make the most out of CDs to earn even more interest on your money without much effort on your part.
CD Laddering
CD laddering involves dividing your total investment into CDs with staggered maturity dates. So, instead of putting all your money in a five-year CD, you might invest in CDs with one, two, three, four, and five-year terms. This setup lets you access some of your funds periodically, which is ideal if liquidity is a priority for you.
Timing the Market
Interest rates fluctuate over time, and buying when rates are higher can boost your returns. Keep an eye on economic trends and interest rate changes so you’ll know when to act. It’s challenging to time market shifts, but staying in the know can give you an idea of what to expect in the near or distant future regarding rates.
Using Online Banks
Online banks operate more efficiently than traditional banks and have far less overhead. Consequently, they can pass these cost-savings on to their customers through reduced fees and more competitive rates on financial products, including CDs.
Exploring Special Offers and Promotions
Banks sometimes have special promotions with increased rates for a limited time. These deals can provide better returns on your CDs and are designed to attract more deposits from new and existing customers. You can stay current on these types of offers by checking your financial institution’s website often and subscribing to financial newsletters.
Conclusion: Should You Open a CD?
A CD may be ideal if you want to invest but prefer not to put your money at risk. But you must be ok with committing your money to the bank or credit union for the entire term to earn the advertised APY. If you anticipate needing access to it sooner rather than later, a money market account or high-yield savings account may be ideal for you.
