Finding a safe and reliable method to grow your savings can be challenging. While many turn to stocks or high-yield savings accounts, a certificate of deposit (CD) remains a popular choice for those seeking a secure, low-risk investment.
CDs are savings accounts that offer a fixed interest rate for a set period, provided by banks and credit unions. Although they might seem old-fashioned compared to newer financial products, they continue to deliver appealing benefits, especially for conservative investors who prioritize stability over high returns.
In this article, we'll explore all aspects of CDs—from what they are and how they work to the different types available and how to choose the right one for your financial needs.
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What is a CD account?
A certificate of deposit is a type of savings from banks or credit unions where you deposit your money for a fixed period, and in return, you earn a guaranteed interest rate. Unlike regular savings accounts that let you withdraw funds anytime, CDs lock in your money for a term—ranging from a few months to several years. In exchange for this commitment, you typically earn a higher interest rate compared to a traditional savings account.
The period you commit your money to a CD is called the “term.” Once this term ends, your CD “matures” or reaches “maturity” and you can withdraw your original deposit along with any interest earned. CDs are popular for their security and predictability. They are considered low-risk investments because they’re typically insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per depositor, per insured bank, for each account ownership category. This means your money will be protected even if the bank fails.
Types of CDs
Now that you understand the certificate of deposit definition, let's explore the different types of CDs. Each type comes with its own set of features designed to meet various financial goals and needs:
- Traditional CD: This is the most common type of CD. You deposit a fixed amount for a set term, and at the end of that term, you receive your principal plus interest. Traditional CDs typically offer higher rates compared to other savings options, but they also come with penalties for early withdrawal.
- Jumbo CD: Jumbo CDs require a larger minimum deposit, usually $100,000 or more. In exchange, they often offer slightly higher interest rates, making them an ideal choice for those with substantial savings who want to earn more on their investment.
- No-penalty CD: A no-penalty CD lets you withdraw your funds before the term ends without facing the usual early withdrawal penalty. However, these certificate of deposit rates are generally lower than those on traditional CDs.
- Bump-up CD: With a bump-up CD, you can increase your interest rate if the bank's rates rise during your term. Typically, you’re allowed one rate adjustment during the CD’s term. This type of CD is useful if you’re concerned about locking in a rate when interest rates might go up.
- Step-up CD: Similar to a bump-up CD, a step-up CD features an interest rate that increases automatically at predetermined gaps throughout the CD’s term. This can offer more interest-earning potential if rates are expected to rise, though the initial rate may be lower than that of a traditional CD.
- IRA CD: An IRA CD is held within an Individual Retirement Account (IRA). It offers the same benefits as a traditional CD, with the added advantage of tax-deferred growth if it’s in a traditional IRA, or tax-free growth if it's in a Roth IRA.
- Brokered CD: These CDs are offered by brokerage firms rather than banks. They may provide higher rates but could come with additional risks, such as market fluctuations affecting the value of your investment.
- Zero-coupon CD: With this type of CD, you buy it at a discount and it matures at its full face value. Unlike other CDs, you don’t receive periodic interest payments. Instead, the interest compounds and is paid out at maturity.
- Call CD: This type of CD can be redeemed by the bank before the maturity date, typically if interest rates drop significantly.
What are the pros and cons of a certificate of deposit?
While CDs have their advantages, they also come with some drawbacks. It’s important to weigh these before deciding if a CD is the right investment for you.
Advantages of a certificate of deposit
- Fixed interest rates: Once you lock in a rate with a CD, it stays the same, ensuring a predictable return on your investment (unless you choose a bump-up or step-up CD).
- Safety: CDs are among the safest investment options available. With FDIC insurance, you don’t have to worry about losing your principal investment even if the issuing bank fails.
- Savings autopilot: The set term of CDS encourages you to leave your money untouched, helping you avoid the temptation to spend your savings prematurely. This makes them a good tool for meeting specific savings goals.
- No maintenance fees: Unlike some investment accounts, CDs usually don’t have maintenance fees, and the interest you earn is shielded from market volatility.
Disadvantages of a certificate of deposit
- Lack of flexibility: CDs can be inflexible. If you need to access your funds before the CD matures, you might face early withdrawal penalties.
- Inflation risk: While CDs offer a fixed return, they may not keep up with inflation, especially in a low-interest-rate environment, which could reduce your purchasing power over time.
- Lower returns: CDs generally provide lower returns compared to riskier investments like stocks or bonds. For long-term growth, other investment options might offer higher returns.
- Opportunity cost: By locking your money into a CD, you might miss out on potentially better investment opportunities that arise during the term of the CD.
Understanding CD rates
CD rates determine the amount of interest you’ll earn over the term of your CD and are influenced by both economic factors and the policies of financial institutions. Generally, CD rates are tied to the Federal Reserve's interest rate. When the Fed raises interest rates, CD rates often increase as well. Conversely, when the Fed lowers rates, CD rates tend to drop.
Factors influencing CD rates
- Term length: Longer-term CDs usually offer higher rates because you’re committing your money for a more extended period.
- Deposit amount: Some banks offer higher rates for larger deposits. A jumbo CD, which typically requires a deposit of $100,000 or more, may offer better rates than a standard CD, for example.
- Market conditions: The overall economic climate, including inflation and the demand for loans, can influence how much interest banks are willing to pay on CDs.
- Bank competition: Competition among banks can influence CD rates. Banks may offer higher rates to attract new customers or retain existing ones.
- Your relationship with the bank: Some banks offer preferential rates to customers with larger balances or longer banking relationships.
How to compare CD rates
When comparing CD rates, it's important to consider both the interest rate and the annual percentage yield (APY), which reflects how often interest is compounded. A CD with a slightly lower interest rate but more frequent compounding—such as daily or monthly—might offer a better return than one with a higher rate but less frequent compounding.
You should also take into account the penalties for early withdrawal. Some CDs may offer attractive rates but come with significant penalties if you need to access your funds before the term ends. Be sure to weigh the rate offered against your potential need for liquidity.
Shopping around at different banks, credit unions, and online institutions can help you find the best CD rates. Just remember to choose a reputable financial institution with a strong track record.
CDs vs. savings and money market accounts
When figuring out where to park your money, it's important to compare CDs with other popular savings options. CDs, traditional savings accounts, and money market accounts each have their own benefits and drawbacks, depending on your financial goals and how quickly you might need to access your cash.
CDs vs. savings accounts
Both are considered low-risk investments, but CDs typically offer higher interest rates than savings accounts because your money is locked in for a fixed term.
On the other hand, savings accounts provide more flexibility, allowing you to deposit and withdraw funds as needed without penalties, though they generally offer lower interest rates.
CDs vs. money market accounts
Money market accounts often offer higher interest rates than regular savings accounts but usually lower rates than CDs. However, depending on market conditions, some money market accounts may offer rates that are competitive with short-term CDs.
Money market accounts provide more flexibility than CDs, allowing for a limited number of withdrawals or transfers each month. They also come with additional features like check-writing capabilities and debit card access.
However, money market accounts typically require a higher minimum balance than savings accounts, which could be a barrier for some investors. In contrast, CDs often have varying minimum deposit requirements based on the term and bank, but once a CD is opened, you can’t add more funds until it matures.
Why would someone use a certificate of deposit?
Certificates of deposit are a popular choice for those who want a safe and predictable way to grow their savings. Banks typically issue CDs, and they're insured by the FDIC, so your money is protected even if the bank runs into trouble. Plus, since your money is locked away in a CD, it can help you avoid the temptation to spend it impulsively.
Another perk of CDS is their fixed interest rate. Unlike savings accounts, stocks, or bonds, which can have fluctuating rates, CDs offer a guaranteed return over a set period. This makes them ideal if you want to know exactly how much you'll earn and when you'll get it.
CDs are also a solid option for short- to medium-term financial goals. Whether you’re saving for a down payment on a house or planning a major purchase, a CD can help you stay on track with a clear maturity date.
How to invest in and open a CD account
Many banks and credit unions allow you to open a CD account online, making the process more convenient.
- Choose a bank or credit union: Select a reliable financial institution that offers competitive CD rates and meets your needs.
- Determine the CD term: Decide how long you want to commit your money and determine how much you want to invest. Longer terms usually come with higher interest rates. Remember, the term you choose will lock in your funds for that duration.
- Minimum deposit: Be aware of the minimum deposit required for the CD you're interested in.
- Open the account: Complete the necessary paperwork and fund your CD account.
- Monitor your CD: Once your CD is open and funded, monitor it regularly. Keep track of the maturity date, as you’ll need to decide whether to withdraw your funds, roll them into a new CD, or move them to another investment.
FAQs
Can you open a CD with $500?
Yes, you can open a CD with as little as $500 at many banks and credit unions. However, minimum deposit requirements vary by institution and CD term, so it’s important to check with your bank to see what options are available. Some banks may offer CDs with lower minimum deposits, while others may require a larger initial investment.
What is the difference between a CD and an FD?
A CD (certificate of deposit) is a fixed-term savings product offered by banks and credit unions in the U.S., where you deposit money for a set period in exchange for a higher interest rate. A fixed deposit (FD) is a similar product offered in many other countries with comparable terms and benefits. Both CDs and FDs are low-risk investments with fixed returns over a predetermined term. The key difference lies in the terminology and regional availability.
What is the biggest negative of putting your money in a CD?
The most significant drawback of investing in a CD is the lack of liquidity. Once you deposit your money into a CD, it’s locked in for term duration. Withdrawing funds early usually triggers a penalty, which can reduce the interest earned or even the principal amount. Additionally, if interest rates rise after you’ve locked in your rate, you won’t benefit from the higher rates.
Can you withdraw money early from a CD?
Yes, you can withdraw money from a CD before it matures, but doing so typically results in an early withdrawal penalty. This penalty can range from a few months’ worth of interest to a percentage of the principal, depending on the terms of the CD and the financial institution.
What happens when a CD matures?
When a CD matures, the deposit term ends, and you can withdraw your initial investment along with the interest earned. Most banks and credit unions offer a grace period—usually seven to 10 days—after maturity. During this time, you can choose to withdraw the funds, roll them over into a new CD, or transfer them to another account. If you don’t take any action, the bank may automatically renew the CD for the same term, though the interest rate could be different.