What Is a Certificate of Deposit (CD)?

What Is a Certificate of Deposit (CD)?
••• MonthiraYodtiwong/iStock/GettyImages

Whether used for a specific savings goal or as part of a larger investment strategy, a certificate of deposit account lets you save your money for a specific period of time and generally earn a better interest rate than you'd see with a basic savings account. This special savings account offers you more stability and security when compared to riskier investments like bonds and stocks, but it can have some drawbacks when it comes to liquidity and limitations on earnings. Before opening a CD account, learn about the features and pros and cons, and compare the types of CDs available to decide which would work best as an investment tool for you.

Understanding Certificate of Deposit Basics

When you open a CD account at a credit union, traditional bank or online bank, you usually need to commit to putting a minimum amount of at least $500 to $1,000 in the account for an extended term that you choose from the bank's selections. Usually, you'll find CDs with terms ranging between six months and five years, but some special accounts could have terms as long as 10 to 20 years or even as short as one month.

You usually get multiple choices when it comes to how long the term runs and whether the interest will change at any point during the term. Typically, you'll see higher interest rates for longer terms due to the commitment you have to make. While the bank holds the money in your CD, you usually see interest accrued either every three to six months. You may either let it accrue within the account or get a check for the interest amount for most CD types.

Depending on the type of CD and your account terms, you may have the option to add money during the term so that you can increase your earnings. Otherwise, you may purchase an additional CD to invest more money. The bank intends for you to keep all the money in the CD until the maturity date arrives, but you may also renew for another term. But if you do need to take money out early for some reason, you can usually expect to pay an early withdrawal fee and may see your interest rate also decline per your bank's terms.

Exploring Certificate of Deposit Advantages

When choosing a certificate of deposit as a type of investment tool, you get the following benefits:

  • Higher interest rates: When compared to the very small amount of interest you usually get in a regular savings account, a CD's interest rate tends to run several times that percentage. For example, your local bank may just pay 0.10 percent for your basic savings account but offer as much as 0.80 to 1.50 percent for a CD account. You can easily compare banks through online tools to find the best interest rate for the term and type of CD you want. Generally, expect the best rates when you choose a credit union or online-only bank.
  • Stability in earnings: Although some types of CD accounts have the interest adjust over the term, you can expect a lot of predictability and stability with a CD. Specifically, you won't have to worry about losing the principal like you could with stocks or bonds. You'll at least get your deposited balance plus the interest accrued according to the bank's CD account terms.
  • Variety of term lengths: You'll have peace of mind knowing that you get to choose how short or how long you want to keep the money in the account. So, if you're using the CD for retirement savings, you can choose the longest term available, while a shorter term can work for an emergency fund or major purchase. You'll need to assess your comfort with the term length and interest rate versus the expected time you'll need to access the money.
  • Diverse CD options: While most are familiar with the traditional type of CD account, you actually get many options. For example, you can find CDs with very high interest rates, flexible access to your money, interest rate changes and even an upfront discounted purchase price. This means you can easily find one that doesn't take you outside your comfort zone and still offers the features you find most important.
  • FDIC coverage: Rather than worrying about losing your CD funds due to market changes or bank failure, you can rest assured that your money gets insured through the Federal Deposit Insurance Corporation. This means you can have up to $250,000 protected in your CD for each depositor. Other investments like bonds, mutual funds and stocks don't come with this security.
  • Simple account opening process: You can expect an easy setup process for a CD with a basic application, deposit and signed account agreement. You can even open a CD account entirely online with money transferred from an existing bank account. You can also expect guidance from the financial institution should you need help choosing the right CD.
  • Often low fees: Fees vary depending on the type of CD as well as its terms, but usually any fees charged will be low as long as you properly use the account. The most common fee is for early withdrawals and may be a portion of the interest earned or a percentage of the withdrawal amount, among other arrangements. You can avoid this by simply waiting until maturity or choosing a more flexible CD option. CDs can also have brokerage fees if you sell the account, but such accounts usually don't have early withdrawal penalties.
  • Access for emergencies: Although you may face a penalty, your CD funds will still be there to access if you need them for an emergency.

Considering Certificate of Deposit Disadvantages

While CDs can offer stability and numerous financial benefits, you should be aware of some of these drawbacks that come with putting your money in this type of account:

  • Lower return than other investments: While usually better than storing cash at home or in a low-yield savings account, a CD typically offers a less competitive rate than bonds and stocks. For example, the average stock market return over time runs around 10 percent in comparison. However, that higher return means added risk where you can also lose a lot of money.
  • Inflation as a factor: Depending on the interest rate you get and taxes paid on those earnings, you may feel concerned your CD doesn't keep up with inflation. Even if it does slightly, your purchasing power may decrease by maturity depending on how prices rise.
  • Potential withdrawal penalties: Unless you get a CD that doesn't penalize for early withdrawals, you have to be careful not to touch the funds until maturity. Otherwise, the fees can easily eat into your profits.
  • Taxes due to earnings: As with other income sources, taxes apply to interest earned on a CD. So, you'll need to subtract those from your interest earned.
  • Risk of fixed interest rate: If your type of CD has a fixed rate, you can lose out when market interest rates increase. On the other hand, keep in mind that you could come out ahead if they drop since you'd keep your set rate.

Comparing Common Types of CDs

When shopping around for a CD, you'll find many options that can vary depending on how the interest works, how easily you can remove money and how much risk is involved. While there are more, a handful of CD types available include:

  • Traditional CD: This is the most common type of CD that comes with early withdrawal penalties, lower deposit requirements and terms usually up to five years. You'll usually get a fixed interest rate.
  • Jumbo CD: As the name implies, this CD type is made for large investments, typically of at least $50,000 to $100,000. You'll usually see a slightly higher interest rate, but this type otherwise works similarly to a traditional CD.
  • Brokered CD: Rather than getting this type of CD through a regular credit union or bank, you obtain it through a brokerage that will help find you the best rates through various financial institutions. This can mean higher interest rates but also fees to have this kind of account. On the other hand, you can sell brokered CDs if you need the funds and usually won't see withdrawal penalties, but brokerage fees apply for transactions.
  • No-Penalty CD: This kind of CD usually has a shorter term of a max of 12 to 13 months and may give you less interest. However, you can usually take money out without paying any early withdrawal fee if needed. Banks usually make you wait a small amount of time – such as one week – before you can take money out of this kind of account.
  • Step-up/bump-up CD: These CD types allow you to increase your interest rate over the term, but this usually means a lower starting rate. This happens in steps with the step-up option and through your choice with the bump-up option. Either option requires careful consideration of possible market rate changes.
  • Callable CD: This type of CD usually offers higher interest, as with a callable bond, and it allows for early redemption if the issuer decides to use the call option before maturity. Often, the bank will do this if interest rates drop since they will want to take advantage of a better deal.
  • IRA CD: If you're saving for retirement, this type of CD allows you to have little risk for a small return over an extended time. They tend to have large initial deposits but allow for regular contributions per IRA rules.
  • Zero-coupon CD: Rather than getting regular interest payments, you buy this kind of CD at a discount and receive the full value when it matures. Depending on the terms, beware that the bank could redeem this kind of CD early as with a callable CD.

Using CDs for Investment Purposes

When using CDs for investment purposes, you have a few strategies to consider. First, you could use one for a single purpose like an emergency fund or vacation fund and hold the money until the term ends. On the other hand, you could use multiple CDs alongside other investments like stocks, bonds and annuities to save for retirement and build long-term wealth. If your strategy involves taking money out early, you'll want to keep a close eye on the market, choose a CD with the least penalties and best rates and time your transactions carefully.

Further, some investors choose to use a CD ladder to try to have flexibility when a large investment amount is involved. Rather than putting all the money in a single long-term CD, you might put smaller yet equal amounts in CDs with varying maturity lengths. For example, you may take a $20,000 investment and open five CDs of $4,000 with maturity dates of one to five years. This could help you make use of higher interest rates as you open or renew CDs, and it's easy to add more CDs to your portfolio with the funds split up.

Now that you know the basics of CDs, you can decide whether to add them to your investment portfolio. If so, you can start researching and comparing CD options and possibly speak with a financial advisor or banking representative to find a good fit and open your account.

Summary

A certificate of deposit account lets you save your money for a defined period of time and generally earns a better interest rate than a basic savings account.

References