Certificates of Deposit: What Are They and How Do They Work?
A CD, or certificate of deposit, is a type of time deposit offered by banks that provides individuals with a fixed interest rate on their deposited funds for a specified period of time.
Certificates of Deposit (CDs) are essentially bank accounts that offer a guaranteed yield for a set period of time. These terms can range from as short as one month to as long as ten years, with common lengths between three months and five years. It's essential to consider when you might need access to your money before investing in a CD.
An Overview of CDs
CDs function differently from common savings accounts. Once opened, you typically cannot add funds or make withdrawals at will. However, you do secure a fixed rate of return. Here's a breakdown of a CD’s essential features:
- Term: Every CD has a term, specifying the amount of time your money will remain in the account, earning interest.
- Early Withdrawal Penalty: If you decide to withdraw your funds before the CD’s term ends, you'll likely incur an early withdrawal penalty. This penalty is calculated based on a set number of days' worth of interest, with the amount varying depending on the bank's policy and the CD's term length.
- APY: The APY—Annual Percentage Yield—represents your CD's rate of return, typically fixed. This rate is one of the main advantages CDs have over traditional savings accounts. You can use a CD calculator to determine how much interest your CD will earn over its term. A higher CD APY means a higher total interest earned.
- Minimum Opening Deposit: Unlike a standard savings account, you cannot continue adding funds to a CD once opened. Some banks require a minimum deposit for opening a CD, while others do not.
- Grace Period: Once a CD's term ends, there's a grace period during which you can either withdraw the funds or roll them over into a new CD. Banks usually provide a grace period between five and ten days. If no changes are made during this period, most banks will automatically roll the balance into a new CD.
Where to Open a CD
CDs are offered by banks, credit unions, and brokerage firms. Credit unions often refer to them as share certificates. You can also purchase CDs through a brokerage firm, known as brokered CDs, which are bank-issued CDs sold on the secondary market via brokerages.
Are CDs Insured?
CDs are insured if the issuing institution is a bank backed by the Federal Deposit Insurance Corp. (FDIC) or a credit union backed by the National Credit Union Share Insurance Fund (NCUSIF). This insurance means that if the bank or credit union fails, you can recover your money up to $250,000 per depositor, per ownership category, per institution.
Why Choose a CD?
CDs can be ideal for saving money for a purchase or expense at a specific time in the future, such as buying a car or making a down payment on a home. Since there's usually an early withdrawal penalty, they are also useful for safeguarding funds you don't intend to spend. However, they should not be used for emergency funds due to their lack of liquidity.
Drawbacks of CDs
While CDs are considered low-risk investments, they may not yield the highest returns compared to investments in the stock market. To earn potentially higher returns with higher risks (such as loss of principal), you can research other types of investments.
How Much Money Do You Need to Open a CD?
Minimum CD deposit requirements vary among banks, with some banks having no minimum deposit requirements, while others may require higher amounts depending on the institution and the term length chosen.
Types of CDs
There are various types of CDs, each with unique features or greater flexibility compared to standard CDs. You can find specialty CDs that offer additional perks, such as bump-up CDs which allow you to increase the rate of the CD if rates rise during its term, or no-penalty CDs which permit you to withdraw the funds early without a penalty.
Choosing the Right CD
When selecting a CD, consider the following factors:
- CD Term Length: Select a term length based on when you'll require access to the funds, considering your financial goals.
- Special CD Features: Some banks offer CDs with added features, such as no-penalty or bump-up CDs.
- Minimum Deposit: Make sure you can meet the minimum amount required for the chosen CD.
- Interest Rate: After deciding on a term length and deposit amount, look for a CD with a competitive APY.
- Early Withdrawal Penalty: Compare the early withdrawal penalties of potential CDs; if two CDs are similar, you might opt for the one with the lower penalty to minimize costs if an early withdrawal is necessary.
What Happens When a CD Matures?
When a CD matures, it enters a grace period, allowing you to withdraw the funds without a penalty or roll them over into a new CD. If no changes are made during the grace period, the bank will usually renew the CD with the same term as the previous one. It's essential to remember your CD's maturity date, especially if you need the funds, as withdrawing them after the grace period expires may result in an early withdrawal penalty, and the renewed CD may not earn a competitive yield.
Pros and Cons of CDs
Pros
- Federally insured (within limits)
- Fixed Interest Rate and Predictability
- Higher APYs than traditional savings or money market accounts
Cons
- Lack of Liquidity
- Penalty for withdrawing money before the maturity date
- Risk that rates on new CDs will go up during your CD's term
- Lower returns than other investments, such as stocks (but with significantly less risk)
CDs vs. Savings Accounts
CDs and traditional savings accounts both serve purposes in your financial strategy, although not everyone may require a CD.
- Savings Accounts offer greater flexibility for funds you might need to access quickly, as withdrawals can usually be made without fees. This makes savings accounts suitable for emergency funds or short-term goals.
- CDs are better for funds you don’t plan to spend soon or need in the near future. Since you lock the funds in a CD, it can help keep you from spending them impulsively.
- CDs are for depositing money you have already saved, whereas savings accounts can build your savings over time.
- Savings account APYs can vary over time, while CDs offer fixed rates.
Building a CD Ladder
If you want to open a CD but aren't sure about the best term length, consider implementing a CD ladder strategy. Here, you open multiple CDs at once with various maturity dates. This way, you can benefit from competitive APYs on longer-term CDs while gaining access to some of your funds sooner with shorter-term CDs.
To build a CD ladder, decide how much you'd like to save and how often you'd like funds to become available from matured CDs. For example, let's say you have $5,000 to invest and want funds available every year:
- $1,000 in a 1-year CD
- $1,000 in a 2-year CD
- $1,000 in a 3-year CD
- $1,000 in a 4-year CD
- $1,000 in a 5-year CD
With this setup, a CD matures each year. When each CD matures, you can choose to extend the ladder by reinvesting the money in a new CD, or you can choose to use the money for planned expenses or other investments.
Utilize our website's CD ladder calculator to help you build a CD ladder tailored to your budget and timeline.
Frequently Asked Questions about Certificates of Deposit
- Choosing a CD term length: Select a term length based on when you'll need access to the funds, such as planning a vacation a year in advance or intending to buy a house in a couple of years.
- Impact of Federal Funds Rate on CDs: Changes to the federal funds rate generally affect CDs. Many competitive banks raise their APYs when the Federal Reserve raises rates and lower APYs when the Federal Reserve cuts rates. Additionally, a bank's need for deposits may affect CD rates. For instance, newer banks may offer higher APYs to attract customers from established banks.
- Types of CDs: In addition to traditional CDs, there are no-penalty CDs, jumbo CDs, bump-up CDs, step-up CDs, zero-coupon CDs, callable CDs, and IRA CDs.
- Loss of Money with CDs: Generally, it's difficult to lose money on CDs. FDIC-insured CDs are secure up to the FDIC limit, and the main way to lose money on a CD is by making an early withdrawal that incurs a penalty large enough to cover the lost interest and principal.
- When comparing different types of accounts for personal-finance management, it's worth noting that while savings accounts offer greater flexibility with regards to withdrawals, CDs (Certificates of Deposit) can provide higher Annual Percentage Yields (APYs) for your money.
- For those planning ahead for future expenses or purchases, or aiming to safeguard funds they don't intend to touch, money market accounts and CDs might be suitable investment options in finance, as they offer a fixed interest rate. However, they differ in terms of liquidity – CDs typically have early withdrawal penalties whereas money market accounts provide the possibility of withdrawals at any time.
