Certificate Of Deposit (CD): Defined And Explained
Sarah Li Cain5-minute read
March 22, 2022
One of the many ways to park your cash for short-term savings is opening a certificate of deposit (CD) account. These types of accounts offer a relatively secure way to store your savings, often with a guaranteed rate of return.
That being said, they’re not for everyone. Before opening an account, let’s take a look at what a certificate of deposit is and whether it’s the right fit for your savings needs.
What Is A Certificate Of Deposit (CD)?
A certificate of deposit (CD) is a time-deposit savings account that offers higher interest rates than most savings or money market accounts. CDs are issued by banks, thrift institutions and credit unions.
A CD offers higher interest rates since the customer has to agree to make a lump sum deposit and leave it in the account for a specified period of time. It’s up to each financial institution to determine rates and CD terms offered, as well as the penalties imposed for early withdrawals.
Like savings accounts, CDs are federally insured, either through the Federal Deposit Insurance Corporation (FDIC) or National Credit Union Administration (NCUA). These types of accounts are considered the low end of the investment risk spectrum compared to stocks and bonds, where funds are not insured and returns aren’t guaranteed.
How Does A CD Work?
You can open a CD much like a traditional savings account — the main difference is the terms of your deposit, including the certificate of deposit rates and term length. That’s why it’s important to shop around to find the best rates and terms that best fit your investment needs.
When shopping around, consider the following factors before making your decision:
- Interest rate: You’ll be able to receive a predictable rate from your initial investment over a predetermined time period. This means the financial institution will not change your rate, leading you to reduced earnings. However, if rates rise after you open the account, you won’t be able to take advantage of them. That’s why it’s a good idea to find the best rates you can – do your best to compare the same term lengths and initial deposit amounts.
- Term length: The term will be the amount of time you’ll agree to keep your funds on deposit to avoid any penalties. Depending on the institution, terms can range from a few weeks to a few years. The maturity date is when your CD term ends. That’s when it’s fully matured and you can withdraw your money with no penalties.
- Principal amount: This is the amount of money you agree to deposit when you open a CD. Some financial institutions may allow you to make additional deposits, but in most cases, you’re only allowed one lump sum during account opening. Make sure the account you ultimately go with is one where you can afford to make the initial deposit.
Once you decide on the CD you want to open, make sure to read the fine print of the agreement so you know what you’re getting into. Read for conditions like early withdrawal penalties – fees you may need to pay if you make a withdrawal before the maturity date – to determine what you could pay. Other terms like what happens when your CD matures if you don’t provide instructions will be helpful.
Once you’ve funded the account, the financial institution will provide you with statements, either paper or electronic, monthly or quarterly. Your interest payments will also be deposited into your CD, with compounding interest.
What Happens To The CD At Maturity?
Once your CD matures, you have a few options:
- Roll over the CD: Your financial institution typically rolls over existing funds into a new CD that would match the term of your existing account, or at least as close as possible. For instance, if you have a 26-month CD, your financial institution might roll it over into a 24-month one.
- Transfer funds: You can open a different CD account (one with a different term length), or use it to fund a checking, savings or money market account at the financial institution.
- Withdraw the matured funds: You typically have a choice of an internal bank transfer, an external one or having the funds mailed to you via paper check.
Your financial institution will also let you know what happens when you don’t make a decision – in most cases it’ll roll over your existing CD. It’ll also give you what’s known as a grace period, the number of days where you can make changes to your CD (such as withdrawing funds or using the money to fund a different type of CD account) during that time. You should receive a notice when your CD is about to mature so you’ll have ample time to notify the financial institution what you want to do with your money.
The Pros And Cons Of A CD
Certificates of deposit have both advantages and disadvantages, so it’s best to consider both to ensure that this savings tool fits your specific needs.
Pros Of CDs
Though generally true for all financial institutions, the pros may depend on your specific CD offering.
- Low-risk investment: CDs offer a guaranteed rate of return, best for those with a more conservative risk tolerance. That way, you know that you’ll earn a specified amount of money as long as you leave it in the account for the agreed-upon term.
- Higher interest rates: Compared to savings accounts or money market accounts, certificates of deposit tend to have higher rates of return, so you can enjoy the fixed rate even if other deposit accounts drop theirs.
- Federally insured: The money in your CD is insured up to $250,000 with FDIC (for banks) or NCUA for credit unions.
Cons Of CDs
Although there are advantages to opening a CD, there are also downsides. These include:
- Earning less over time: Compared to other investment options like stocks and bonds, CDs will earn you less over the long haul.
- Early withdrawal penalties: If you empty or make a partial withdrawal from your account before maturity, you may be subject to a penalty. Depending on the financial institution, it could be a flat fee or a percentage of your earnings. In some cases, if your earnings can’t cover the penalty, you’ll have to fork over some of the principal amount.
No rate increases: In most cases, you’ll earn a set interest rate, even if interest rates increase during your CD term.
What Is A CD Ladder And How Does It Work?
A CD ladder can enable investors to access higher rates typically offered by longer CD terms like 5 years, while allowing access to a portion of your money each year. Here’s how it works: you take the upfront capital you want to invest in CDs and divide it up into five equal amounts. Then you put the first fifth into a 1-year CD, another into a 2-year CD and so forth through to a 5-year CD.
When the first CD matures in a year, you can withdraw that amount and use it to open a 5-year CD. The next year, when the 2-year CD matures, you invest that into another 5-year CD. You keep doing this every year whenever a CD matures and you’ll end up with five 5-year CDs earning the best rates possible. The advantage here is that it’ll mature each year, so if you happen to need the funds, not all of it is locked in for 5 years.
The Final Word
Investing in a CD account isn’t the fastest way to earn money, but it can offer you the reassurance that you’ll earn a guaranteed rate of return and that it’s FDIC- or NCUA-insured. Finding a CD with a competitive rate will also help you earn as much interest as possible. It’s important to choose a strategy that works with you, such as using a CD ladder and ensuring you won’t face early withdrawal penalties.
As with all types of investments, it’s crucial you determine your investment risk tolerance and research saving and investing tips before moving money around. Talk to a financial advisor or professional to make sure this investing option is right for you.
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