What Is a CD (Certificate of Deposit)? - Types & When to Choose

Views 7103Jan 4, 2024

If you want to earn more interest on your savings, a certificate of deposit (CDs) may be a considerable option. The trade-off is that your money is locked up for a set period of time when you open a CD. The interest rate is fixed so you know exactly how much you'll earn by the end of the CD's term. To understand how CDs work and what sets them apart from other savings options, let's explore the basics. What exactly is a CD and what are its unique features?

What is a CD Account?

Certificates of deposit, commonly referred to as CDs, are a type of savings account that typically offers higher interest rates than standard savings accounts. CDs require you to keep your money deposited for a set period of time, called the term, in exchange for the higher rate. When the CD matures at the end of the term, you get your money back plus the interest it earned. CD rates are primarily influenced by economic factors like inflation and the federal funds rate. Understanding what CDs are and how their rates are determined can help you make more informed decisions about where to put your savings. Now let's explore what exactly CDs are and how they work.

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Understanding Certificates of Deposit (CDs)

Opening a CD is similar to opening a standard bank account. The difference is you agree to four things:

1. The interest rate is fixed, providing a predictable return over the CD's term. This rate can't later be reduced to lower your earnings.

2. The term is the length of time you agree to leave the funds on deposit to avoid penalties. It ends on the maturity date at which time you can withdraw penalty-free.

3. The principal is the amount you deposit when opening the CD.

4. The bank or credit union sets terms like early withdrawal penalties and whether your CD auto-renews at maturity if no instructions are given.

Once established, the CD is administered like other bank accounts with monthly/quarterly statements and interest payments that compound.

CDs offer fixed, guaranteed returns that are generally higher than savings or money market accounts. But you lose liquidity by locking up funds for the term to avoid penalties. CDs are very low-risk since they are FDIC insured. Overall, CDs provide modest but safe returns for those wanting to conserve capital.

When to Select a CD Account

A certificate of deposit can be a good place to keep your money if you have specific savings goals and want a guaranteed return. Here are some key reasons to consider opening a CD:

You Have Designated Savings - If you are setting aside money for a large planned purchase in the future like a down payment on a house, buying a car, or saving for college tuition, a CD can help protect those funds. The fixed interest rate and term lock in your returns so you earn interest while deterring you from the temptation to dip into those savings early.

You Want Low-Risk Returns - CD rates may not be as high as stock market returns during booms, but CDs offer the security of avoiding market losses during downturns. With FDIC insurance protecting your principal, CDs provide slightly higher returns than regular savings with virtually no risk. This makes them appealing if you want to earn interest without worrying about losing your money.

You Can Wait for Access to Your Money - The trade-off for CDs' security and higher rates is limited access to your money during the term. Make sure you don't need the money anytime soon when choosing your CD's maturity date. Standard CDs charge early withdrawal penalties, so they may not be right if you want to make withdrawals.

Pros and Cons

CDs offer some advantages but also disadvantages to weigh.

Pros:

Higher interest rates than savings/money markets
Guaranteed, predictable returns less risky than volatile stocks/bonds
Federally insured up to $250,000 by FDIC/NCUA
Locked-in term deters spending temptations

Cons:

Penalties for early withdrawal
Typically earns less than stocks/bonds long-term
Inflation can erode fixed-rate value over time

How to Choose an Appropriate CDs

When deciding which certificate of deposit (CD) is right for you, there are several factors to consider:

Term Length - CDs come in various term lengths, usually ranging from 3 months to 5 years. Shorter-term CDs generally have lower interest rates, while longer-term CDs earn higher rates. Think about when you'll need access to the funds and choose a term length that aligns with your financial goals.

Interest Rate - Compare interest rates across multiple banks and credit unions. Online banks sometimes offer the highest rates. Consider both the annual percentage yield (APY) and how interest is compounded.

Minimum Deposit - Many CDs require a minimum deposit amount to open the account, often $500-$1000. Make sure you have enough to meet the minimum for the CDs you are considering.

Penalties - If you withdraw funds before the CD matures, you'll face an early withdrawal penalty, usually equivalent to a number of months' worth of interest. Choose a CD with milder penalties if you think you may need access before maturity.

Add-Ons - Some CDs have add-on features allowing you to deposit more funds during the term. This can be useful if you want to build on your CD investment over time. Check if add-ons are allowed and if there are any restrictions.

CD Ladder - A CD ladder allows you to earn higher interest rates while keeping some funds readily available. This strategy spaces out CDs in staggered maturities. For example, you might open a 1-year CD, a 2-year CD, a 3-year CD, and a 4-year CD. This creates a "ladder" where one CD matures each year. You can withdraw that CD's principal and interest without penalty, reinvesting it if desired. The longer CDs in the ladder earn higher rates, yet you can access some cash annually. CD ladders provide returns similar to long-term CDs but with more flexibility.

When comparing CDs, calculate the total interest you would earn over the full term at the advertised APY. Do the math to see which CDs offer the highest return for your deposit amount and timeline. Read all fine print to ensure you understand any fees and policies regarding early withdrawals. With some research, you can find the most suitable CD for your financial situation.

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How Many Types of CDs Are There?

While traditional CDs have fixed terms and rates, banks and credit unions offer a variety of CD types with unique features:

No-Penalty CDs - These allow you to withdraw funds early without a penalty, in exchange for lower interest rates. They offer more flexibility than standard CDs.
High-Yield CDs - Offered by online banks and credit unions, these tend to have interest rates higher than brick-and-mortar banks.
Jumbo CDs - Require high minimum deposits, often $100,000. They may provide slightly higher rates for large balances.
IRA CDs - These are regular CDs held within an Individual Retirement Account for tax-deferred growth.
Bump-Up/Step-Up CDs - Allow you to request a rate increase during the term, either on-demand or on a set schedule. Rates start lower than fixed CDs.
Brokered CDs - Purchased through a brokerage firm instead of a bank directly. Include callable CDs that allow early termination by the broker.
Add-On CDs - Allow additional deposits after opening, making them more flexible.
Zero-Coupon CDs - Pay all interest at maturity rather than periodic payments, allowing compound growth.

In summary, while standard CDs have fixed terms and rates, other types add useful features like flexibility, higher rates, larger balances, tax advantages, or customized interest payment options.

FAQ for CD Account

1. What is the difference between a CD and savings account?

The key difference between a CD account and a savings account is access to your money. Savings accounts allow easy access to your funds, with the ability to withdraw at any time. However, some banks charge fees if you make too many withdrawals.

CD accounts restrict access to your money until maturity. Withdrawing early from a CD almost always incurs a penalty. The amount of the penalty depends on the specific bank's policies, but it is typically a loss of several months' worth of interest. So savings accounts offer flexible access while CDs prioritize earning higher rates in exchange for locking up your money for a set period.

2. How Are CD Earnings Taxed?

CD interest is applied to your account by the bank at regular intervals, usually monthly or quarterly. This interest accumulates and the total earned for the year is reported to you so you can declare it as income on your tax return.

Some people assume CD interest is only taxed when you withdraw the funds at maturity. But for tax purposes, earnings are taxed in the year they are applied to your account by the bank. This remains true even if you don't withdraw the interest until later.