Financial Terms / C - D / Certificate of deposit (CD)

What is a certificate of deposit (CD)?

A certificate of deposit (CD) is a special type of savings account that offers a fixed interest rate for a set period. When you open a CD, you agree to keep your money in the account for a specific time, usually ranging from three months to five years. In return for this commitment, the bank pays you a higher interest rate than you'd typically get with a regular savings account.

Key features of CDs

Fixed interest rate: CDs offer a guaranteed return on your investment, which is great for predictable savings growth.
Set term length: You choose how long you want to keep your money in the CD, from a few months to several years.
One-time deposit: Unlike regular savings accounts, CDs usually require a single initial deposit that stays in the account until it matures.
FDIC insurance: CDs from federally insured banks are protected up to $250,000 per depositor, making them a very safe investment option.
Early withdrawal penalties: If you take your money out before the CD matures, you'll likely face a penalty, usually a portion of the interest earned.

How CDs differ from savings accounts

While CDs and savings accounts are both tools to save money, they have some key differences:

Interest rates: CDs typically offer higher interest rates than regular savings or money market accounts.
Access to funds: With a savings account, you can withdraw money whenever you need it. CDs limit access to your funds until the maturity date.
Deposits: Savings accounts allow you to make additional deposits anytime. With CDs, you usually make one initial deposit that stays put until the term ends.
Flexibility: Savings accounts offer more flexibility for everyday use, while CDs are better for specific savings goals or as part of a broader financial strategy.

CDs can be a smart choice if you're looking to save for a specific goal and don't need immediate access to your money. They're great for things like saving for a down payment on a house, a new car, or a vacation. Some people also use CDs as part of their emergency fund strategy, ensuring a portion of their savings earns a guaranteed return.

However, it's important to consider the current economic climate when deciding to invest in a CD. In a rising interest rate environment, locking your money into a long-term CD might mean missing out on better rates later. On the flip side, if rates are falling, a CD can protect your savings by locking in a higher rate.

To manage this risk, you might consider creating a CD ladder. This strategy involves opening several CDs with different term lengths. As each shorter-term CD matures, you can reinvest in a new long-term CD or take advantage of potentially higher rates elsewhere.

Some banks also offer special CD products to address interest rate concerns:

Bump-up CDs: These allow you to request a rate increase during the term if rates rise.
Step-up CDs: These provide automatic rate increases at set intervals during the CD's term.

By understanding what a CD is and how it compares to other savings options, you can make an informed decision about whether it's the right tool for your financial goals.

How CDs Work

Opening a CD

To open a certificate of deposit (CD), you need to choose a bank or credit union that offers CDs. You can compare interest rates online to find the best deal. When you're ready to open a CD, you'll need to provide identification and your contact information. You'll also need to decide how you want to receive interest payments.

The process of opening a CD can take 5 to 20 minutes, depending on whether you're applying online, over the phone, or in person. If you're an existing customer, it might be easier. Some banks encourage online applications, while others require you to visit a branch.

When opening a CD, you'll make a single deposit. Unlike savings accounts, you usually can't add money to a CD after the initial deposit. You can fund your CD by transferring money from another account, mailing a check, or depositing a check at a branch.

Interest rates and terms

CDs offer fixed interest rates for a set period. This means your rate stays the same throughout the CD's term. Terms typically range from three months to five years. Generally, longer terms offer higher interest rates.

When comparing CDs, look at the Annual Percentage Yield (APY) rather than just the interest rate. APY shows the total interest earned, including compound interest. This gives you a more accurate picture of your potential earnings.

CDs often have higher interest rates than regular savings accounts. This is because you're agreeing to leave your money untouched for a specific period. However, if you need to withdraw your money before the CD matures, you'll usually face an early withdrawal penalty. This penalty can be several months' worth of interest, so it's important to choose a term you're comfortable with.

Maturity and renewal options

When your CD reaches its maturity date, you have several options. You can:

Withdraw your money without penalty
Renew the CD for another term
Move the money to a different account

Banks typically offer a grace period of 7 to 10 days after the maturity date. During this time, you can make changes to your CD without facing penalties. If you don't take any action during the grace period, many banks will automatically renew your CD for the same term at the current interest rate.

It's important to note that the interest rate for a renewed CD might not be the same as your original rate. It will likely match the bank's current rate for new CDs of that term. To make the most of your CD, set a reminder for the maturity date. This way, you can decide whether to renew or explore other options based on current rates and your financial goals.

Some people use a strategy called CD laddering. This involves opening multiple CDs with different terms. As each CD matures, you can either withdraw the money or reinvest it in a new CD. This approach provides a balance of higher interest rates and more frequent access to your funds.

Types of CDs

Traditional CDs

Traditional CDs are savings accounts that hold a fixed amount of money for a set period. You can choose terms ranging from 3 months to 5 years or even longer. When you open a traditional CD, you agree to keep your money in the account until it matures. In return, you get a fixed interest rate that's usually higher than what you'd earn with a regular savings account.

The main drawback of traditional CDs is the early withdrawal penalty. If you need to take your money out before the CD matures, you'll face a penalty that can eat into your earnings. This penalty often equals several months' worth of interest.

High-yield CDs

High-yield CDs offer higher interest rates than traditional CDs. These are often found at online banks, which can offer better rates due to lower overhead costs. The terms and conditions of high-yield CDs are similar to traditional ones, but the higher interest rates make them more attractive for savers looking to maximize their returns.

When comparing high-yield CDs, look at the Annual Percentage Yield (APY) rather than just the interest rate. APY shows the total interest earned, including compound interest, giving you a more accurate picture of your potential earnings.

Jumbo CDs

Jumbo CDs require a larger minimum deposit, typically $100,000 or more. In exchange for this higher deposit, jumbo CDs often offer slightly better interest rates than regular CDs. These are popular with institutional investors and high-net-worth individuals who need a safe place to park large sums of money.

The benefits of jumbo CDs include:

Higher interest rates than traditional CDs
FDIC insurance up to $250,000
Fixed returns that can help stabilize an investment portfolio

However, jumbo CDs also have drawbacks. They tie up a large amount of money, and the returns may not keep pace with inflation. Also, if interest rates rise during the CD's term, you might miss out on better opportunities.

No-penalty CDs

No-penalty CDs, also known as liquid CDs, offer more flexibility than traditional CDs. They allow you to withdraw your funds before the maturity date without incurring a penalty. This feature provides peace of mind if you think you might need access to your money sooner than expected.

The trade-off for this flexibility is usually a lower interest rate compared to traditional CDs. Also, there may be some restrictions:

An initial lock-up period (often about a week) where you can't withdraw funds
You might need to withdraw the entire balance if you decide to take money out early
Some banks may limit the number of penalty-free withdrawals you can make

When choosing a CD, consider your financial goals and how soon you might need access to your money. Each type of CD has its pros and cons, so it's important to compare options and read the terms carefully before making a decision.

FAQs

What is a Certificate of Deposit (CD) and what are its workings?

A Certificate of Deposit, or CD, is a type of bank deposit that locks your funds for a predetermined period, known as a term. During this term, the bank offers a fixed annual percentage yield (APY), providing a secure and predictable method of saving money.

Can you explain how a CD functions in simple terms?

A CD is set up for a specific duration called a term, during which your money is kept in the account to earn a fixed interest rate. For instance, if you choose a 1-year term, the interest rate remains constant for the entire year. Terms offered by most banks range from six months to five years.

What would be the earnings from a $1,000 CD in one year?

The earnings on a $1,000 CD over a year can vary depending on the interest rate. For example:

At a 6.00% interest rate, you would earn $60, totaling $1,060 after one year.
At a 5.75% rate, it would be $57.50, summing up to $1,057.50.
At a 5.50% rate, the earnings would be $55, making it $1,055 in total.

How much would a $500 CD grow in five years?

A $500 CD would accumulate about $117.15 over five years, which represents an increase of approximately 23.4% on the initial deposit.