If you’ve got money you won’t need for some time, but can’t risk losing it, a certificate of deposit might be for you. A certificate of deposit, often called simply a CD, is a type of account offered by banks and qualified financial institutions that allows you to lock in the current interest rate for a specified period of time. The amount of time and the amount you put in is flexible, so whether you're saving for a new phone, a car, or even a house, there's a CD that could work for you.
Better Interest Rate
CDs generally offer better interest rates than other deposit accounts that allow you to access your money whenever you want, such as a savings account. When the bank knows that it’s going to have your money for a predetermined period of time, it’s willing to pay you more interest. The longer the term of the CD, the higher the interest rate. In addition, many banks pay higher interest rates for larger CDs.
CDs offer security that more risky investments, like stocks and mutual funds, don’t. First, you receive a fixed rate of interest and you won’t lose money. Second, even if your bank goes out of business, your money is covered by the Federal Deposit Insurance Corporation. As of 2013, the FDIC guaranteed up to $250,000 of deposit accounts per depositor at each bank. For example, if you've got the bulk of your life savings in CDs and the bank goes out of business, as long as you don't have more than a quarter million at any single bank, you won't lose any of your money.
Early Withdrawal Penalties
The biggest drawback to using CDs is that you must leave the money in the account until the CD matures or pay a substantial early withdrawal penalty. The penalties vary from bank to bank, but typically hit you with three months’ worth of interest if your CD has a term of under a year, and six months’ of interest if you have a term longer than a year. If you haven’t earned that much interest yet, many banks will dip into your original deposit, so you’ll lose money.
Interest Rate Changes
CDs lock you into a fixed rate for the life of the CD, which can be either a blessing or a curse. If market interest rates fall, you’re happy to still be paid the old, higher interest rate. For example, if you get a CD that pays 3 percent, but the market rate falls to 1.5 percent, you’re golden because you’re still getting paid 3 percent. But if interest rates rise, it’s a curse because you’re stuck earning only the lower interest rate. In the example, if rates rose to 5 percent, you’d be stuck earning just 3 percent on your CD.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."