A certificate of deposit is a time deposit account, which lets you earn interest on money you hold for a certain period. Banks, online financial institutions and credit unions offer these accounts which you use as a savings vehicle, but that differ from savings accounts and money market accounts in certain ways.
For instance, you can withdraw cash from savings and money market accounts if need be. When you deposit your money in a certificate of deposit account, however, it’s assumed that you won’t withdraw cash from that account until your CD matures.
How a CD Works
Like a savings account, opening a CD account requires you to make a minimum initial deposit. You must also agree to keep your money on deposit for a certain time. Your financial institution sets the CD terms that you can choose from. The terms may range from 30 days to more than 10 years.
Typically, the longer the CD term, the higher the interest rate your deposit earns. Occasionally, to promote the CD account, an institution may offer a high interest rate for a short-term deposit.
Fixed Annual Percentage Yield
In most cases, a CD's annual interest rate is fixed. This means the interest rate for your deposit will be the same for the entire CD term. Should you choose to deposit your savings in a bump-up or step-up CD, however, the bank may raise the interest rate during the CD term.
Once your CD matures, you can withdraw your original deposit and the interest earned. Unless you state you want to withdraw your savings at the end of the CD term, your bank might automatically roll your deposit into a new CD.
Certificates of Deposit Benefits
The use of a certificate of deposit account as a savings vehicle offers many benefits. Here are a few of the primary certificate of deposit advantages.
Secure Account to Save Cash
Like a money market account and savings account, a certificate of deposit is a relatively safe way to save your cash. The money you deposit in a CD is insured if you purchase it through an FDIC-insured bank. This means that a deposit of up to $250,000 is insured by the federal government in the event your bank goes out of business.
The FDIC coverage limit applies to the depositor, the particular account ownership category and the bank. The National Credit Union Association applies the same limits to the cash you deposit at federal credit unions and the majority of state-chartered credit unions.
Predictable and Guaranteed Returns
Another certificate of deposit advantage is that when you use a certificate of deposit to save money, the interest you will earn during the CD term is predictable. Typically, a fixed rate is assigned to the CD based on its term.
Many financial institutions provide a certificate of deposit calculator whereby you enter the cash amount you will deposit along with the annual percentage yield (ANY) to see the interest you’ll receive at the end of the CD term. For instance, if you deposit $2,000 and earn 1 percent APY over a five-year term, your deposit will grow to $2,626 at the end of that term.
As the example illustrates, you can tailor your certificate of deposit terms, including the interest rate and terms, to achieve a long-term goal.
Read More: How Are Certificates of Deposits Taxed?
Relatively High Interest Rates
The interest rates on a CD may be higher than that for savings accounts and money market accounts due to the requirement that you deposit a certain amount of cash for a set time. The bank, the interest rate environment and the CD term influences the interest rate and APY your savings will earn.
The CD Laddering Strategy
The CD laddering strategy is a technique that accounts for changing interest rates and the need for liquidity. To build a CD ladder, you open multiple CDs with differing interest rates and maturity dates.
With this strategy, the maturity date of one CD varies from that of another, so you can revise your savings strategy according to the current economic environment. For instance, at one point you might take your money out and invest it elsewhere. At another time, you might roll the savings and interest of a mature CD into a new one that earns a higher rate.
No Account Maintenance Fees
Unlike some savings and money market accounts, a certificate of deposit account does not usually charge a monthly maintenance fee. Assuming you leave your cash in the account until the CD matures, you won’t incur fees that decrease the net benefit of the account.
Disadvantages of Certificates of Deposit
As with any financial vehicle, a certificate of deposit is not the best option to meet all your investment goals. Before you open a CD account, consider the disadvantages and certificate of deposit risks.
Lack of Accessibility to Cash
With a certificate of deposit, you’re not allowed to make a withdrawal of cash until the CD matures without penalty. For this reason, the CD is a poor choice for an emergency savings fund.
Penalty for Early Withdrawal
Due to the restrictions placed on a CD account, you should limit your deposits to the cash you won’t need to spend in the immediate future. Although you can withdraw money from the account before the CD maturity date, your bank may charge an early withdrawal penalty. The penalty may be all or a percentage of the interest earned or a flat fee.
Interest Rate Risk
The financial benefit of using a CD as a savings tool rises and falls with interest rates. A certificate of deposit risk is that the yield of a CD increases as interest rates rise. The reverse is also true.
The CD, however, carries an interest rate risk in that the interest rates earned on CDs can climb while your cash is locked in a CD that pays a lower rate.
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The prices for goods and services rise over time. If inflation outpaces the return you earn on a CD, it means your earnings will fail to keep pace with the prices of goods and services. When this situation occurs, your cash will not keep pace with your expenses.
The Risk/Return Relationship
The less the financial risk you are willing to assume, the lower will be the return on your investment. So, while committing your savings to CDs will grant you stable returns and security, it’s less likely your savings will keep pace with inflation.
Billie Nordmeyer is an IT consultant of 25 years standing. As a senior technical consultant for SAP America and Deloitte Touche DRT Systems, a business analyst, senior staff, and independent consultant, Billie has worked across the retail, oil and gas, pharmaceutical, aeronautics and banking industries. Billie holds a BSBA accounting, MBA finance, MA international management as well as the Business Analyst and Software Project Management certificates from the Cockrell School of Engineering at the University of Texas at Austin.