Aug 18, 2023
What Is a Certificate of Deposit?
|What is a certificate of deposit?|
A CD, or certificate of deposit, is a type of deposit account in which you earn a fixed interest rate for keeping your money in the account for a predetermined period. CDs are offered by banks and credit unions, and they typically provide higher interest rates than regular savings accounts.
If you’re seeking a stable and reliable savings option, a certificate of deposit could offer the right combination of safety, predictable returns, and term lengths to meet your financial goals. Learn about the benefits and risks of CDs, including penalties for early withdrawal, to decide if opening one is right for you.
In this article, we’ll cover:
Certificates of deposit vs. traditional savings accounts
CDs and savings accounts are both vehicles for earning interest on your money. The primary difference is the amount of freedom you have to move money in and out of the account. Unlike a savings account, where you can deposit and withdraw money freely, Traditional CDs require you to keep your funds untouched for a specified length of time, known as the term. CD terms can range from a few months to several years. The reward for this longer-term commitment is earning a guaranteed, and often higher, return.
Unlike savings accounts, whose variable interest rates may change at any time, a CD’s interest rate is locked in when you open it. And banks usually offer a higher interest rate for CDs compared to other saving options. This makes CDs an appealing choice for those seeking a steady path toward financial growth.
There are, of course, liquid CDs, which offer more flexibility by allowing early withdrawals without penalties. However, because of this flexibility, liquid CDs typically offer lower interest rates compared to traditional CDs with fixed terms.
How does a CD work?
There are three key elements of a CD you’ll want to understand:
- Principal: This is the amount of money you deposit when you open your CD. Most banks require a minimum balance, commonly $500 to $1,000, though some institutions offer options with no minimum deposit. Once you open your CD, you generally can’t deposit more money on top of the initial principal.
- Term: Every CD has a fixed term: the amount of time you have to leave your money in the account. If you withdraw early, you’ll usually incur a penalty in the form of lost interest. And once the term is up, you have to withdraw your money.
- Interest rate: Throughout the term, your money earns interest at a fixed rate established when you open the CD, which is usually higher than the rate for a savings account. Because the rate is fixed, it won’t change during your term, even if interest rates go up or down for other types of accounts.
Opening a certificate of deposit is fairly straightforward. Determine how much money you’d like to save and the term length that suits your financial goals. You’ll commonly find terms ranging from six months to six years. Consider how long you can leave your funds tied up in a CD, as well as your timeline if you’re growing your money for a specific goal.
With your ideal principal and term length in mind, research options from different financial institutions. If you’re focused on growing your money as much as possible, you may make your decision based on which bank offers the highest interest rate. The average rate for CDs as of 2023 was 0.20% to 1.72% APY, but many institutions offer much higher rates, often up to 5.00%.
The longer you leave your money in a CD, the more it will grow thanks to the power of compounding interest, and many banks offer higher interest rates for longer terms. For instance, if you put $10,000 into a CD with a rate of 1.78%, you’d accrue approximately $172 in one year. If you went with a three-year term at that rate, your money would earn about $524 in interest.
Once your term is up, the CD matures and you withdraw your initial deposit and all the interest earned.
Key features of CDs
Thanks to their fixed terms and interest rates, CDs provide a guaranteed return. And as long as you open one with a bank that’s a member of the FDIC (which most are), your money is covered by FDIC insurance, or NCUA insurance in the case of credit unions. However, early withdrawal penalties may apply if you need access to your funds before the account matures.
- Fixed term: CDs have a fixed duration, which means you cannot access your money until the term ends without the potential for penalties.
- Fixed interest rate: The interest rate on a CD remains constant throughout the term, so you know exactly how much your money will grow.
- FDIC insurance: Most CDs are insured by the FDIC or NCUA up to $250,000, so you have virtually no risk of losing money.
- Penalties for early withdrawal: Most CDs charge a penalty if you withdraw funds before the maturity date. While the penalty amount varies from one financial institution to another, you’ll usually forfeit some of the interest you’ve earned. Some banks offer liquid CDs (also called no-penalty CDs) that allow you to access your funds early without penalties.
Pros and cons of certificates of deposit
Before opening a certificate of deposit, it’s important to weigh their benefits and risks. On the plus side, CDs’ security provides peace of mind for risk-averse investors and, their fixed interest rates ensure stable growth. However, CDs have limited liquidity due to fixed terms and early withdrawal penalties, and their returns may be lower compared to investment options like stocks, bonds, and funds.
Advantages of CDs include:
- Safety: With government-backed insurance, CDs are considered a very low-risk investment option compared to other investment options, protecting your funds in case the financial institution encounters difficulties.
- Predictable returns: Fixed interest rates provide stable and predictable returns over the CD’s term, so you’ll know exactly how much you’ll earn by the end of the investment period.
- Flexible terms: You can choose from various term lengths to align with your financial goals, whether you’re looking to make a short-term investment or if you have a longer-term objective.
- Guaranteed interest rate: The Federal Reserve adjusts interest rates periodically, which affects the rates banks offer. If interest rates drop while you have your money in a CD, you enjoy that higher interest rate for the full term.
Disadvantages of CDs include:
- Limited liquidity: Due to fixed terms and early withdrawal penalties, you can’t access money before the term without losing some interest, though liquid CDs offer more flexibility.
- Lower returns: While certificates of deposit are safe, their returns can be lower compared to more aggressive investment options. Putting your money into a CD may result in missed opportunities for potentially higher returns, especially during a bull market.
- Inflation risk: CD interest rates may not keep up with inflation rates, especially when inflation is high. During periods of high inflation, the real value of the money invested in CDs can erode.
- Interest rate fluctuations: While the fixed rate of a CD provides predictable returns and is a hedge against falling interest rates, you lose the opportunity to put your money into a higher-yield option if interest rates rise while your money’s tied up in a CD.
- Early withdrawal penalties: If you need to withdraw your money before your certificate of deposit matures, penalties can involve forfeiting a portion of the interest earned.
Types of CDs
Various certificate of deposit types cater to different financial needs and saving goals. Each type of CD offers unique features and benefits, from increased accessibility and flexibility to higher interest rates.
- Traditional CDs: The most common type of CDs are standard certificates of deposit with fixed terms and interest rates.
- Liquid CDs (aka, no-penalty CDs): Liquid CDs allow you to withdraw funds early without incurring penalties. Usually, partial withdrawals aren’t allowed; you’ll have to close the CD entirely, so you’ll lose the opportunity to keep earning interest.
- Bump-up CDs: These CDs give you the option to request a higher interest rate if national rates increase during your CD term.
- Callable CDs: Callable CDs give the bank the right to recall the CD before its maturity date. Because of this, banks often offer higher interest rates as an incentive.
- Jumbo CDs: Jumbo CDs require a higher minimum deposit, often offering better interest rates in return.
Grow your savings securely
Whether you’re looking to build your money with a higher interest rate than your standard savings account or seeking a stable source of returns for a specific financial goal, a certificate of deposit can be a reliable, low-risk way to grow your savings.
CDs are often an attractive option for people seeking high-yield investment options, and many investors open one in addition to holding other higher-risk investments like stocks, bonds, and funds. With the right type of CD, you can ensure that your saving strategy aligns with your individual needs and aspirations.
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