How Do CDs Work?

A certificate of deposit offers a guaranteed return on your money. So, it’s no wonder consumers often turn to it as a safe investment method. If you aren’t exactly sure how they work, this guide will familiarize you with the specifics, the pros and cons of these savings vehicles, and how they stack up to the competition.

What are Certificates of Deposits (CDs)?

A certificate of deposit (CD) is a savings account offered by banks and credit unions. It pays a fixed interest rate over a set period of time.

Unlike a regular savings account, the interest rate on a CD is usually higher. You agree to keep your money in the CD for the entire term. This can range from a few months to several years. If you withdraw your funds early, you may face an early withdrawal penalty.

How Do CDs Work?

The way in which CDs operate is relatively straightforward.

Interest Rates

Again, you can expect to earn more with a CD than you would with a regular savings account. And if you choose to do business with an online bank, your earning potential could be even greater since they have lower overhead costs than brick-and-mortar banks.

Terms

There are several CD terms to choose from, ranging from a few months to several years. It’s common for CDs with longer terms to boast higher APYs, although some banks and credit unions offer competitive yields on shorter-term CDs to attract increased deposits.

Opening Deposit and Minimum Balances

Most financial institutions require an opening deposit for CDs. The amount varies by bank or credit union, and some do not require a deposit at all to get started, although you’ll need to fund the account within a certain time frame to keep it from closing.

Principal

The principal is the initial amount of money you deposit into the CD. It stays locked in for the entire duration of the term. Protecting your principal is a primary goal with CDs. Since they offer a fixed return, your principal is generally safe unless there are early withdrawal penalties involved.

Maturity Date

This date represents the end of the CD’s term or when you can withdraw your investment plus interest without incurring penalties. You can also roll the funds into a new CD or transfer them to a different account.

Certificates of Deposit (CDs) Example

To illustrate how CDs work, assume you have $4,000 to invest. If you choose a 1-year CD with a 3.5% APY, you’ll have access to $4,140 at maturity.

How Do CD Rates Compare?

Here’s a closer look at how CD rates compare to similar offerings.

How CD Rates are Determined

It’s worth understanding how CD rates are calculated before comparing them to the competition. Generally, it varies by the issuing bank or credit union and the CD term you select.

Factors Affecting CD Rates

Economic conditions also play a role in CD rates. When the Fed rate rises, CD rates often follow suit and vice versa.

CD Rates vs. Other Saving Options

Again, the rates for regular savings accounts often pale in comparison to CD rates. That’s not the case for high-yield savings accounts, though, as they may have rates that rival those of CDs, although they could change over time since they are variable. However, CD rates usually promise a guaranteed return.

Types of CDs

There are several options to choose from, as outlined below:

• Traditional CD: This is the most common type of CD. You put your money in for a fixed term. The interest rate stays the same until the term ends. These CDs are a safe choice if you want a guaranteed return.
• Bump-Up CD: These CDs let you raise your interest rate if rates go up. You can usually do this once during the term. They often start with a lower rate than traditional CDs.
• Step-Up CD: With a step-up CD, the interest rate increases at set intervals. This can be a good option if you expect rates to rise over time. The starting rate might be lower than other CDs.
• Liquid CD: A liquid CD allows you to withdraw part of your money without a penalty. The trade-off is that these CDs typically offer a lower interest rate compared to traditional CDs.
• No-Penalty CD: Similar to a liquid CD, but usually with a fixed term. You can take out your money early without paying a fee. This type often comes with a lower rate than a traditional CD.
• Jumbo CD: A jumbo CD requires a large minimum deposit, often $100,000 or more. In exchange, it may offer a higher interest rate. It’s an option if you have significant savings to invest.
• IRA CD: An IRA CD combines the features of an Individual Retirement Account with a CD. It’s a way to save for retirement with the security of a fixed rate. It’s typically sold by banks and credit unions.

Pros and Cons of CDs

As with any banking product, CDs have their share of benefits and drawbacks to consider before opening a new account and investing your hard-earned money.

Pros

• Stability: When you put your money in a CD at a bank that is a member of the Federal Deposit Insurance Corporation (FDIC), your savings are insured by up to $250,000. The same level of coverage extends to CDs held at credit unions through the National Credit Union Administration (NCUA).
• Predictability: Another advantage is the higher interest rates compared to regular savings accounts. Plus, you can lock in a specific rate for the duration of the term, which can range from a few months to several years. This fixed rate makes it easier to predict how much your money will grow over time.
• Financial discipline: CDs can also assist with financial discipline. Once you deposit your money, you cannot access it without incurring an early withdrawal penalty. This limitation encourages you to save for the entire term length, fostering better-saving habits.

Cons

• Lack of liquidity: Money in a CD is locked until the maturity date. If you need to withdraw early, you usually face an early withdrawal penalty. This can reduce your earned interest and even some of the principal.
• Limited growth potential: While the interest rates are higher than regular savings accounts, they are typically lower than what you might gain from investing in stocks or mutual funds. This makes CDs less suitable for long-term growth if you’re looking to increase your savings significantly.
• Forfeited earnings: If inflation rates rise significantly, the fixed interest rate might become less appealing. This could happen as the purchasing power of your money could diminish over time. It could lock you into a potentially unfavorable rate during high inflation periods.

What to Consider When Opening CDs

Before opening a new CD, be mindful of the following:

• Interest rate or APY: Does the financial institution offer a competitive APY?
• Term length: Do the available terms work for you?
• Early withdrawal penalties: What are the fees if you need to pull funds before the term ends?
• Deposit insurance: Does an FDIC- or NCUA-insured institution offer the CD?
• Inflation: Is the CD rate higher than the inflation rate?
• Opening deposit requirements: Can you comfortably afford to invest this amount?
• Bump-up options: Is there an option to change your rate if market conditions improve?

How to Open CDs

When you’re ready to move forward, here’s what to do next:

• Step 1: Research your options and select the bank or credit union you want to do business with.
• Step 2: Choose the type of CD that works best for you.
• Step 3: Decide on the term length.
• Step 4: Complete the application online or at a physical branch (if applicable).
• Step 5: If approved, fund your CD and watch your money grow.

Where to Get CDs

CDs are offered by banks, credit unions and brokerages. Keep in mind that you’ll typically find the best rates with online entities, as they have lower overhead costs.

Conclusion: Is Opening a CD Worth It?

A CD could make sense if you want a safe way to earn a guaranteed return on your and can afford to stash the opening deposit away for some time. Otherwise, a high-yield account could be a more suitable option.

Frequently Asked Questions About CDs