Certificates of deposit (CDs) are simple and secure investments that can give you a decent return on your balance. They are a fantastic option if you’re looking for an interest-earning account that you can set and forget.
With a federally insured financial institution, your money is safe in the event of a bank run or closure. In exchange for leaving your money for the term, CDs may offer higher interest rates than other savings options.
Many types of CDs are available to match your financial needs, whether you’re looking for higher interest rates, more accessibility or different term durations.
So what are certificates of deposit, and how do they work?
What is a certificate of deposit?
A certificate of deposit is a specific type of savings account designed to give you a better return in exchange for less flexibility with your funds.
While typical savings accounts only earn interest of less than one percent each year, CD accounts often pay out much higher returns. Unlike a traditional savings account, however, you can’t simply withdraw money from a CD account when you need it. You’ll have to wait until the CD’s maturity date, a period of time that can range anywhere from a few months to several years after the account is opened. If you withdraw before that date, you can be penalized with fees.
How does a certificate of deposit work?
You deposit a lump sum into an account for a fixed period of time, during which the account holder is paid interest by the bank, generally daily or monthly. Once a CD reaches its maturity date, the account holder has the option to either withdraw their original deposit plus the interest earned or renew the CD for an additional term.
There are three main factors to understanding how a CD works:
- Deposit amount: The dollar amount that is put into the account
- Term: The period of time until the account matures
- Interest rate: The annual percentage yield the bank pays the account holder in interest
Let’s look at an example to understand what type of return you might expect from a CD account. For instance, if you invested $10,000 into a 3-year CD with a 4% fixed interest rate, your account balance would look something like this:
| Starting balance | Interest earned | Closing balance | |
|---|---|---|---|
Year 1 | $10,000 | $400 | $10,400 |
Year 2 | $10,400 | $416 | $10,816 |
Year 3 | $10,816 | $432.64 | $11,248.64 |
Your initial investment of $10,000 would have grown to $11,248.64 by the CD’s maturity date for a total return of $1,248.64.
Benefits of investing in a certificate of deposit (CD)
CDs are a low-risk investment
Compared to other investment options like stocks and bonds, CDs are generally considered very low risk thanks to their fixed interest rate. This means that when you open a CD, the interest rate you receive won’t change for its entire term.
CDs typically offer higher returns than savings accounts
If the majority of your money has been sitting untouched in a savings account for years, it’s likely been losing value because of inflation. Since CDs typically offer higher interest rates than traditional savings accounts, depositing some of those funds into a CD can help your hard-earned savings keep their value, though in high inflation, CD rates can also fall behind.
However, always make sure to keep enough funds in your savings account that are quickly available to cover major unforeseen events, such as job loss or a serious illness.
CDs have flexible terms
When you open a CD account, you get to choose the terms that best suit your financial needs. If you’re saving up for a major purchase or setting aside cash for holiday spending, a short-term CD that matures in the next few months probably makes the most sense. Long-term goals such as retirement planning or saving for a child’s education, however, might be better suited by a 5-year or 10-year CD.
Risks associated with certificates of deposit
CDs often have penalties for early withdrawal
When your money is kept in a savings account, it’s typically easy to access on short notice for an emergency. When you deposit funds into a CD, however, you should generally plan on not touching the account until its maturity date. While it’s possible to withdraw funds early, you’ll usually be penalized with fees for doing so.
CDs can underperform inflation
The high interest rates offered by CDs are what attract many consumers to them, but you should always compare current CD rates to inflation before making a decision. If annual inflation rises above the interest rate on your CD during its term, you’ll find yourself having effectively lost money by the time it matures.
You’ll have to determine the balance of risk you want to take on in your investment. A CD typically delivers a relatively high rate of return with a very low risk, compared to something like investing in the stock market that could deliver a high return that keeps pace with inflation but can be risky.
CDs are subject to bank stability
Like any type of savings account, CD investments are only as secure as the bank holding them. If your bank goes under, there’s a chance your funds will go with it.
“This was hardly a thought a few years ago but must be a consideration today,” warns Mark Charnet, founder and CEO of American Prosperity Group, a financial estate planning firm.
In the event of bank failure, FDIC insurance will protect the balance of your CD account up to $250,000 – which is why it’s so important to make sure your bank is FDIC-insured.
However, Charnet warns, many customers fail to consider how long it might take to process such a claim. “FDIC insurance is wonderful, but how long would one wait to get their money back?”
Federal law requires the FDIC to make payments as fast as possible, and this can happen as quickly as the next business day after a bank closing. But there are some situations where the reimbursem*nt needs supplemental documentation, and every bank failure is unique, so the timeline may take longer.
How to choose the right certificate of deposit
When considering investing in a CD, there are several factors to take into account:
- Interest rates: Shop around for the best rates. They will vary depending on the financial institution, CD type, accessibility level and term length.
- Duration: CD terms can range from one month to five years or longer. Remember that you usually can’t access your funds without penalty during the term.
- Penalties: Banks and credit unions may charge hefty penalties for early withdrawal. If you think you may need to access the money, consider a no-penalty CD or another savings option.
- Investment amount: How much do you want to invest? Make sure to only to invest money you won’t need during the term.
- Interest payment frequency: Banks may issue interest payments weekly, monthly or at maturity. Collecting payments at the end of the term may be more lucrative because of compounding.
- Market conditions: If interest rates are expected to rise, you may want a shorter-term CD that you can renew at a better rate later. During times of rising inflation, it could outpace CD rates, so another investment may be a better option.
Early withdrawal penalties
CDs offer higher interest rates than other savings options because you’re leaving your deposit for the term.
Your financial institution may charge early withdrawal penalties if you need the money back before maturity. The amount varies depending on the bank and CD terms.
When you cash out early, you lose some of the interest your CD earned or would have earned. For example, if you have a 12-month CD with Bank of America and withdraw your funds early, you will lose 90 days of interest on the amount withdrawn. It’s possible for penalties to even eat into the principal.
Usually, you can’t just take out a portion of the money. If you need any of the funds back, the entire CD will likely end.
Only investing what you know you won’t need during the term is essential to avoid penalties. If there is any uncertainty, a no-penalty CD or a different savings product may be a better option.
Understanding maturity dates
Your financial institution is required to notify you before your CD matures. After maturity, you must instruct the bank on what to do with the funds. There are a few options available:
- Roll it into a new CD: You can open a new CD at the same financial institution. However, shop for better rates first in case the same bank or credit union is no longer offering the best rate.
- Transfer funds to another account: You can deposit the proceeds into another account at the same financial institution, like a savings or money market account.
- Withdraw the funds: You can request that the financial institution send you a check or transfer the money to another financial institution.
While there is usually a grace period to withdraw your funds, keeping track of your CD’s maturity date is crucial. If the financial institution doesn’t receive instructions on what you’d like to do with the CD, it may use your funds to open a new CD with the same terms.
Types of CDs
There are many different types of CDs. Here are some of the most common options:
- Traditional CDs: A traditional CD is a one-time deposit account with a fixed interest rate. You cash it out at the end of the term, and there are typically penalties for withdrawing early.
- High-yield CDs: A high-yield CD is like a traditional one but usually has higher interest rates.
- Bump-up CDs: If your bank raises the APY on its CDs, you can tell it to bump you up to that rate. You’re usually allowed one bump-up per term, but these CDs typically have a lower starting APY than traditional CDs
- Liquid (no-penalty) CDs: Liquid CDs may let you withdraw your money without penalty, but they usually have lower interest rates than traditional CDs.
- Brokered CDs: Brokerages offer CDs you can trade on the secondary market, similar to bonds. However, there’s more risk involved unless you plan to hold the CD until maturity.
How to open a certificate of deposit account
- Choose the bank and CD account you’d like to apply for.
- Fill out an application. You’ll need to provide personal details, so have your ID and Social Security number handy.
- Deposit funds into your CD account. The bank will give you instructions on how to transfer money from your account into your new CD.
- Set a calendar reminder for the CD’s maturity date. When your CD matures, you’ll need to notify the bank right away if you’d like to withdraw your funds – otherwise, your account might automatically renew for another term.
Savvy strategies to maximize CD returns
If you decide CDs are the best investment option for you, there are strategies you can use to maximize your returns.
“Shop around at online banks for high-interest CDs,” said Christopher L. Stroup, certified financial planner and financial advisor at Abacus Wealth Partners, a financial planning firm. “Many of the best CD rates possible in the marketplace can be found at a reputable online bank.”
You should also ensure that you won’t need the funds during the CD’s term.
“CD accounts can charge high penalties for withdrawing money early. Depending on the fine print of your investment, you could lose several months of interest you’ve earned by requesting money before the date of maturity,” said Stroup. “Having a separate emergency fund can help greatly by acting as a cushion against unexpected expenses, which can preserve your CD to maximize returns.”
Stroup also suggests using a laddering strategy to increase your return rate.
“A CD ladder includes splitting your investment across several CDs that each have a different term, such as 3 months, 6 months, 12 months and 18 months. As each of those matures, you can decide to withdraw your investment or reinvest it in a longer-term CD with a higher rate to maximize your earnings.”
Frequently asked questions (FAQs)
CDs are typically safe investments with virtually guaranteed returns. They often pay higher interest rates than other savings options.
You can withdraw money from a CD before it matures, but you’ll usually need to pay an early withdrawal fee. These fees are usually a set period’s worth of interest that can range from 90 days to 12 months. These penalties vary by financial institution, so check your account’s terms for the penalty amount.
Funds kept in a CD account are insured up to $250,000 as long as the bank is insured by the FDIC. To make sure a bank is FDIC-insured, use the FDIC’s BankFind tool.
Standard CDs don’t include an option to add funds once you’ve opened the account. If you think you might want to contribute more down the road, you’ll need to look for an add-on CD account.
If your CD matures while you’re away from home, make sure to communicate with your bank well in advance to explore your options. Your account may automatically renew for another fixed term if you neglect to withdraw the funds in a timely manner.
CDs can often be used as collateral for many types of personal loans. Ask your bank if this option is available to you.
CD accounts mature after a fixed period of time. A CD’s maturity date is typically expressed as a set number of months or years following the date the account is opened, such as six months or five years.
Funds withdrawn from a CD account before its maturity date are subject to an early withdrawal penalty. This fee is determined by the issuing bank, but US law mandates that it must be equivalent to at least seven days’ worth of interest.
