If you’re looking for a secure way to invest funds without the risk of the stock market, a CD is a good tool. The main advantage of a CD is its security, and a higher interest rate than a traditional savings account. But what is a CD account?
A certificate of deposit or CD investment has both a set time period and fixed interest rate. This means you’ll know exactly how much you’ll get out of the CD and when you’ll receive it.
The main disadvantage of a CD is that if you try to access the funds before the term ends, you’ll face a monetary penalty. Here’s what you need to know about a CD account.
Table of Contents
- How does a CD account work?
- How are CD rates determined?
- How much do I need to open a CD account?
- Understanding certificates of deposit
- Types of CDs
- Is opening a CD a good idea?
- What are the risks of a CD account?
- What is a CD ladder?
- What CD terms should I get?
- What happens to my CD after it matures?
- How are CDs taxed?
- CD account vs saving account
- CD investment as a part of financial planning
How does a CD account work?
A CD account works like a savings bond. You can purchase a certificate of deposit (CD) for a term of your choice. In most cases, your options include terms from one month to ten years, sometimes even more.
Essentially, a CD is an agreement between you and the bank. You agree to leave your funds in the bank for a set period of time, and then, the bank agrees to give you a set interest rate. You will receive a CD certificate for the value of the funds and terms.
There are different types of CDs. Common types include no-penalty CDs, high-yield CDs, jumbo CDs, and IRA CDs.
Here’s an example: If you put $5,000 in a standard CD with 2% APR for a five-year term, then after five years you will receive $5,258.
How are CD rates determined?
Certificate of deposit rates are determined by a combination of factors. The most important are the length of the CD and the current interest rates. Every six to eight weeks, the Federal Open Market Committee decides whether to raise, lower, or leave the federal funds rate. Because of this, every six to eight weeks the market interest rates can shift. However, once you open a CD your interest rate for its term is set.
How much do I need to open a CD account?
Each bank or credit union requires a different minimum requirement. Some will allow you to open a CD with as little as $50 while others require a larger deposit. Check with your bank or credit union to find out their minimums, and don’t be afraid to shop around to other lending institutions who offer lower minimums if needed.
Understanding certificates of deposit
Here are the factors that come into play when determining the value of a certificate of deposit.
Certificate of deposit accounts come with fixed rates. It removes the guesswork and probability from investing. You will know exactly how much you can make over time. This can be helpful to calculate and plan for how much you will make over time.
The terms are the set length of time you will leave your funds deposited to avoid penalty. Terms can vary from one month to 10 years. Some investors suggest having CDs of various lengths so that you can access some of your funds after a shorter term rather than investing the full amount in a long-term CD. The terms that are best for you will depend on your short-term and long-term financial needs.
Principle is the amount you agree to deposit when you open the CD. While there are some exceptions to this with specialty CDs, generally your principal is secured in a CD for the duration of the terms. CD funds remain there until the CD matures, which is another way of saying that the term length has passed.
The bank or credit union that you open your CD account with will determine certain aspects of the agreement, like early withdrawal penalties. Discuss these terms with the institution before entering a certificate of deposit with them to avoid surprises. Once you enter a CD, plan to keep it for the full term to avoid penalties.
Types of CDs
Here are some of the most common types of CDs:
- No-penalty CD: As the name implies, a no-penalty CD allows you to take some or all of the principal out of the CD before the term is up without incurring a penalty. These sometimes have lower interest rates.
- High-yield CD: A high-yield CD offers one of the highest interest rates available from banks or lending institutions. They usually have terms from three months to five years. Opening deposits can be $5,000 or less.
- Jumbo CD: A jumbo CD is a regular CD for a larger sum of money. Jumbo CDs usually have higher interest rates. Many banks require a minimum of $100,000 for a jumbo CD.
- IRA CD: You can choose to put money from your individual retirement account into a CD. This is then called an IRA CD.
- Bump-up or step-up CD: A bump-up or step-up CD allows you to raise the interest rate of your CD if the bank or institution raises their interest rates. If your CD has a 1.4% interest rate, and the bank raises their interest rates to 1.7% instead, your CD will be eligible for the interest increase.
- Brokered CD: A brokered CD is purchased through a brokerage firm. They are similar to traditional CDs, except that you can buy and sell them on a secondary market using your brokerage account. If you sell a brokered CD, you can recapture the funds before the terms of the CD are up.
Is opening a CD a good idea?
A CD is useful in multiple situations where you will need cash in a few years. If you want to put aside funds for a special vacation or to buy a new car, keeping those funds in a CD can make sense. Purchasing CDs as part of an overall investment strategy can also be a good idea as CDs are a secure form of investment with predictable returns.
What are the risks of a CD account?
CDs are almost always FDIC insured. They are one of the lowest risk investments. The main risk of a CD with a low interest rate is that inflation will outpace the CD’s interest.
For example, if you take a one-year CD with a 1% interest rate, and inflation climbs 1.7% during that year, the spending value of the principal in your CD will be lower at the end of the year.
Advantages of a CD
Certificate of deposit benefits include:
- Security: CDs are FDIC-insured.
- Predictability: Terms and interest rates are set out at the time of investment.
- Flexibility: You can select CD terms from one month to 10 years.
Disadvantages of a CD
While CDs have some good advantages, there are also some disadvantages to keeping money in CDs. These include:
- Inaccessibility of funds: Once the terms are set, you’ll usually face penalties and fees if you withdraw the principal before the end of the CD term.
- Low interest rates: Compared to other forms of investment, CDs still have very low interest rates that sometimes fail to outpace inflation.
What is a CD ladder?
The CD ladder saving strategy is a way to get the best of CD’s security while mitigating the problems of inaccessibility of funds. With a CD ladder, you divide the total funds you want to put into a CD into four or more smaller amounts and put them into CDs with different term lengths.
For example, if you have $10,000 to invest in CDs, you could purchase 5 CDs for $2,000. Each one could have a different term length so that some of the funds can be available if you need them sooner.
What CD terms should I get?
You can choose between short and longer-term CDs. The term you choose should be based on your goals for the money. If you have a project or big purchase you know the date of that can help you make the decision. For example, if you are saving for your child’s college, a vacation in three years, or a new home in five years, the set deadlines will help determine CD length.
If you are just funding cash for long-term savings into your CD you can go for longer terms as these usually offer higher interest rates.
What happens to my CD after it matures?
When your certificate of deposit matures, you will be notified by your institution. You will have options at that point on how to proceed. The usual options are:
- Roll over the CD into a new CD: With this option, you will re-invest the principal plus interest of the original CD into a new CD. The new CD will have a new set term length and interest rate. This is a good strategy for funds you are saving long-term.
- Transfer the funds into another account: You can also choose to transfer the CD money into savings, checking, or money market accounts to use the funds for other purposes. Your bank can help you process the transfer.
- Withdraw the proceeds: If you want to withdraw the funds from the bank, you can transfer to an external bank account or get a paper check mailed to you. Once a CD matures, the funds are available for however you choose to use them.
How are CDs taxed?
CDs are taxed on interest accrued at the end of each calendar year. Even in the case of a multi-year CD, you are responsible for reporting interest earned on the CD annually. The exception to this is tax-deferred retirement accounts such as an IRA. We recommend consulting an accountant or tax professional about your individual situation.
CD account vs saving account
There are two primary differences between a certificate of deposit and a savings account: interest and availability of funds. In a savings account, you earn a lower interest rate, which is often 0.1% or less these days, but the funds are immediately available when you need them.
A CD, in contrast, offers higher interest rates but less availability of funds. You may not be able to get the capital out until the term of the CD is finished. If you do take funds out, you may be charged penalties or fines.
For this reason, it is always good to have cash in an emergency savings account so you have quick access when needed.
CD investment as a part of financial planning
Certificate of deposit benefits financial planning for everyone. CDs are a powerful investment tool that can be used in conjunction with a savings account for an emergency fund, and other investment strategies. They offer the reliability and security of a savings account with higher interest rates. While your funds are locked into a CD for the term length, creating a CD ladder can give you greater flexibility if you need to access some of the funds before the longest term is complete. Learning what a CD account is and how to purchase CDs is useful for saving—whether you’re saving for retirement or planning your next vacation.
What is the point of a CD account?
A certificate of deposit (CD) account is a way to save funds at a higher interest rate than traditional savings accounts. The interest rate is fixed, so you know how much interest you will make when you buy the CD. A CD is usually fixed for a set period of time, usually between six months and five years.
Where can I open a CD?
You can open a certificate of deposit (CD) through most FDIC insured banks and credit unions. Some banks and credit unions will also allow you to open a CD online.
Can you lose money in a CD account?
A certificate of deposit (CD) account is FDIC insured, so you cannot lose money in a CD account. When you invest in a CD, you will know how much interest you will make in addition to the investment amount.