How to Open a Certificate of Deposit (CD)

How to Open a Certificate of Deposit (CD)
••• kate_sept2004/E+/GettyImages

If you have already set aside three to six months of expenses in a savings or money market account for emergencies, the next step is to start saving for the longer term. You may want to start saving for a down payment on a house, a vacation, a car or tuition for education.

If these are your goals, a good investment to consider is a certificate of deposit. CDs are safe investments that give you a good return and the security of knowing your money will be available when you need it.

What Is a Certificate of Deposit?

A certificate of deposit is an account with a bank or credit union that pays a fixed rate of interest for a specific period of time. An example would be a $5,000 deposit at a bank that pays an interest rate of 2% fixed for three years.

CDs are insured up to $250,000 by the Federal Deposit Insurance Corporation (FDIC) when issued by a bank, and by the National Credit Union Association if the account is with a credit union.

Access to funds in a CD is limited, and withdrawals before the maturity date may be subject to penalties that result in a loss of a portion or all of your accrued interest, which will reduce the annual percentage yield (APY) earned on the CD.

Where Should You Open a CD Account?

You can open a CD account in person at your local bank, or you can obtain a CD with an online bank. Online banks tend to pay slightly higher CD rates since they don't have the expense of maintaining physical branches.

The choice between the two is a personal preference. If you like to deal with your banker in person to discuss your savings plan and investment options, then the local branch is the way to go. On the other hand, if you like receiving the higher rates and don’t feel you need professional advice, then online banks are perfectly fine.

What Documents Do You Need to Open a CD Account?

Each bank has its own requirements, but at a minimum, you will need the following:

  • Social Security Number
  • Identification, such as a driver’s license
  • Date of birth
  • Home address
  • Phone number
  • Email address
  • Money for initial deposit

What Is the Minimum Deposit?

Some banks have no minimum deposit requirement to open a CD account, while others require $1,000 or even more.

Bank of America, for example, requires a minimum of $1,000 to open an account for a standard CD. However, they offer higher rates for their “featured” CDs if you deposit $10,000 or more.

Wells Fargo requires a minimum of $2,500 to open an account, but you can open a CD at CIT Bank with only $1,000.

Online banks that have no minimum requirement are Ally Bank, Capital One and Barclays Bank.

What Interest Rates Do CDs Pay?

Interest rates are constantly changing, so shop around to find the best returns. Online banks will usually have the highest rates, with credit unions coming next and brick-and-mortar banks having the lowest.

Banks will pay even higher rates for amounts, known as Jumbo CDs, over $100,000.

What Maturity Should You Purchase?

The maturity you select depends on your savings goals and when you expect to need the funds. Maturities of certificates of deposit range from 28 days to 10 years. Longer-term CDs pay higher rates than short-term CDs.

You’ll have the most flexibility and more frequent access to your funds with short-term CDs of one year or less. At maturity, you can decide to either use the funds or renew for another one or two years. The disadvantage with short-term CDs is you give up the higher returns available from long-term CDs.

Mid-range CDs, with terms of two to three years, should be used for funds that you can tie up for a few years. But, you want to stay reasonably short term to react to changes in the direction of interest rates.

Certificates of deposit with maturities of four to five years or longer will give you the highest rates. However, you must be absolutely certain you won’t need the funds. Otherwise, you’ll run into heavy early withdrawal penalties that could cost you all of your accrued interest.

What Types of CDs Are Available?

In addition to normal CDs that pay a fixed rate for a set time period, banks offer several kinds of CDs with different features.

Step-Up CDs: A step-up CD raises your interest rate at certain intervals over the life of the CD. The goal is to keep the interest rate in line with the rise of rates in the market. However, the starting rate on step-up CDs is often lower than rates on normal CDs with comparable maturities. Therefore, the annual percentage yield of a step-up CD may turn out lower than a regular fixed-rate CD.

A version of the step-up CD is the bump-up CD. In this case, the investor has the right to ask for an increase in the rate at any time during the life of the CD. The timing is up to the investor.

Add-on CDs: An add-on CD gives you the option to add funds to your existing CD and receive the same rate. If the market for interest rates is falling, you can take advantage by adding funds to your existing CD, which will probably be paying a higher rate than the market.

The amount you can add may be limited by the terms of the CD.

Callable CDs: Callable CDs will pay a slightly higher interest rate compared to CDs with similar maturities, but you have a risk.

If interest rates decline, the bank may call your CD because they want to replace your high-rate CD with a new CD at a lower rate. When this happens, you're faced with finding another CD, but it’ll come with a lower rate.

Liquid or No-Penalty CDs: If you’re not entirely comfortable with locking your money up for several years, a liquid or no-penalty CD could be an option.

These CDs are usually short-term, less than one year, and pay lower rates, but you can withdraw all of your money without penalty at any time before maturity.

Ally Bank and CIT Bank are examples of banks that offer no-penalty CDs.

What Is a Good Strategy to Invest in CDs?

With all of these choices of different types of CDs and varying maturities, your savings strategy may involve setting up a CD ladder.

A CD ladder is a strategy that takes advantage of higher interest rates with long-term CDs while giving you the availability of some of your money more frequently in the short term. If interest rates rise, you’ll have the funds to purchase new CDs at higher rates. If interest rates go down, your long-term CDs will continue to earn their higher rates.

Here’s how a CD ladder works. Suppose you have $15,000 to invest. You could put $3,000 spread evenly over five CDs that mature each year for one to five years. With this strategy, you would have $3,000 coming available each year that you could choose to reinvest in either short-term or long-term CDs, depending on your view for the direction of interest rates.

If you feel that interest rates are going up, you would keep the maturities short. Conversely, if you think that interest rates have topped out and are headed down, you would favor longer-term maturities.