A certificate of deposit, or CD, is a bank-issued savings certificate. A CD is one of the safest investment choices, and in most cases your money is insured by the Federal Deposit Insurance Corporation (FDIC). A fixed rate CD is the traditional form of savings certificate; variable rate CDs become popular when interest rates are expected to increase.
While both types of CDs are low-risk ways to save money while earning interest, the interest rate for variable rate CDs can rise or fall over the term, while fixed rate CDs will maintain a constant rate.
What Is a CD?
A certificate of deposit is a bank savings product. It is usually purchased with a single, lump-sum deposit. When the CD matures, the original deposit amount is returned to the customer plus the interest earned over the term of the CD. If a customer wants to withdraw money before the maturity date, the bank will often assess an early withdrawal penalty, which reduces the amount of interest paid on the certificate. Rates for CDs are set by individual banks. A bank that is eager to attract new customers will often offer a higher CD rate to attract more deposits.
Fixed Rate CD
Most banks offer fixed rate CDs with a variety of interest rates and terms ranging from 30 days to five years or longer. On a fixed rate CD, the interest rate remains the same for the term of the certificate. When the CD matures, the interest rate on a new certificate will be based on rates in effect at the time, which may be higher or lower than what the saver was earning previously. Generally, a longer-term CD will earn a higher rate of interest than a short-term certificate. The higher rate of interest compensates the saver for tying up money for a longer period of time.
Variable Rate CD
A variable rate CD has a fixed term but the interest rate can fluctuate based on criteria set by the bank. The variable rate is usually based on a market index, similar to the rates on a U.S. Treasury security. A saver might choose a variable rate CD if interest rates are low and he expects rates to increase in the future. The interest earned on the variable CD will rise if market rates increase. Of course, rates can also decline, and this would reduce the amount of interest earned on the CD. It’s important that bank customers understand how the CD rate is determined and how often it will be adjusted before investing in a variable rate CD.
Exotic Types of CDs
Investment brokers and banks sometimes sell certificates of deposit with more exotic features. One common type is called a step-up or rising rate CD. The interest rate earned on these CDs automatically increases in regular increments after certain intervals of time. Step-up CDs have long, multi-year terms and the rate usually increases once a year. These CDs often have a “call feature,” which means the issuing bank can redeem a CD rather than pay higher step-up interest rates. Investors should make sure that CDs sold by brokers are FDIC-insured – not all are.