Savings of any kind is an absolute necessity to help you deal with unexpected emergencies and have money available for future spending needs and wants.
While savings accounts are great, you might want to earn more interest than you do on your savings account. If you’re hesitant to invest extra savings in real estate or the stock market, a Certificate of Deposit (CD) could be a good option for you.
A Certificate of Deposit (CD) typically pays a higher rate of interest than a standard savings account, but without the risk of other longer-term investments.
What is a Certificate of Deposit (CD)?
A certificate of deposit (CD) is a type of savings account with a fixed interest rate and a precise maturity date.
When you open a CD account, you make a deposit to a bank, credit union, or other financial institution for a specific time frame (term) at a guaranteed rate of return.
Most CDs do not have fees unless the money is withdrawn before the stated maturity date. Just like any other savings account at a financial institution, CDs are insured by the FDIC (up to $250,000).
What makes a CD different from a regular savings account?
Several factors set CDs apart from a standard savings account. From a fixed term to withdrawal penalties, it’s essential to weigh options carefully and fully understand the conditions for any CD you’re considering.
Each financial institution offers different CD products – with different rates, terms, and penalties. It pays to shop around for the right CD for you.
Set maturity date
Since CDs are term-based accounts, your money is locked up until the CD reaches its maturity date. If you withdraw funds from the CD before the maturity date, you will pay the penalty (penalties vary).
There are many term options for CDs. Some have terms as short as one month and others can span up to 5 years or more. Each financial institution has different terms and conditions.
Penalty to withdraw funds before the maturity date
One downfall of CDs, compared to standard savings accounts, is the penalty to withdraw funds from the account before the maturity date of the certificate of deposit.
Penalties vary by financial institution, which is why it’s important to understand the conditions of a particular CD before funding it.
Most banks charge a penalty equal to a certain amount of your earned interest for early withdrawals.
For example, on a 12 month CD, a bank might charge a penalty equal to 3 months of interest for withdrawing money before the maturity date.
Guaranteed interest rate
Most CDs have a guaranteed, fixed interest rate for the duration of the CD. Generally, the longer the term length of a CD, the higher the interest rate.
Once again, each financial institution is different. Some banks offer exclusive rates on certain CDs and run “specials” allowing you to get a better interest rate on a shorter term CD.
The same term CD at one bank can be as much as .5% or higher than another. Though you shouldn’t make your choice based solely on the rate of return, it’s an important factor when considering which CD is best for you.
No additional deposits after the purchase
Unlike a standard savings account, you cannot make additional deposits to a CD account after the initial investment.
Once you open the account and fund it, that’s it! But that doesn’t mean you can’t have more than one CD open at a time. You can have several CDs at the same or different financial institutions, with varying dates of maturity, interest rates, and penalties.
Minimum deposit amounts
Many CDs have a minimum deposit amount required to open the CD. Once again, this amount depends on the financial institution and the specific CD.
Minimum deposit amounts can range anywhere from $500 all the way up to $25,000+.
How do you know if a CD is a good option for you?
A certificate of deposit might be an excellent option for you if you:
- Don’t need to access the money in the near future
- Have a separate emergency savings account to cover unexpected expenses easily
- Don’t anticipate any large purchases or expenses during the term of the CD, like a roof, a car, or a house
- Don’t want to put the money in long-term investments (like real estate or the stock market) but still want to earn some interest
- Want a higher interest rate than a savings account
Create more flexibility with a CD ladder
If a CD appeals to you, but you’re hesitant to tie up your money for a longer term of 3 to 5 years (to get the highest interest rates), a CD ladder could provide the flexibility you’re after.
A CD ladder means you open up several CDs, each with a different maturity date, so all of your money isn’t tied up into one CD account.
A CD ladder allows you to access part of your money more regularly. Also, staggering maturity dates enables you to gradually shift into CDs with higher returns if interest rates rise. You can use a CD ladder in whatever way works best for you.
For example, let’s say you have $5000. You can deposit the money in five different CDs. You put $1000 each into a 1-year, 2-year, 3-year, 4-year, and 5-year CD.
In one year, your first $1000 CD matures. You can then re-invest that money into a new 5-year CD, continuing the ladder on.
If you continue to do the same thing each year, at the end of 5 years, you’ll have all long-term (5-year) CDs. As a result, you’re earning a higher rate of interest on all of them (since they’re all long-term), but you still have one maturing every 12-months if you need to access the money.
If one year between maturity dates seems too long, stagger them 6 or 9-months apart. You could stagger CDs to mature monthly or quarterly as well.
Different types of CDs
Most of the information on CDs to this point has been focused on a traditional certificate of deposit. But there are different types of CDs offered by some financial institutions.
Bump Up (or Step Up) CD. A bump up CD allows the owner to “bump up” to a higher interest rate if interest rates rise during the term of the CD. Many only allow one “bump up,” but some longer-term CDs may allow multiple bump ups.
Liquid CD. Generally, a liquid CD allows the owner of the account to withdraw funds before the maturity date without penalty, as long as a minimum balance is maintained.
Brokered CD. Brokered CDs are offered by a brokerage company, not a bank. They are similar to bank CDs, but they are bought and sold by the brokerage company. The fees and structure of brokered CDs may be different from the banks. Make sure you understand all the conditions of the CD, including if it’s FDIC insured.
High Yield CD. This type of CD offers higher interest rates than a regular CD. These CDs typically require a larger deposit and longer term.
Jumbo CD. A jumbo CD has a minimum deposit of $100,000.
Variable Rate CD. A variable rate CD has a fixed term, but a fluctuating interest rate. The rate is often determined by a market index and/or formula specified by the financial institution.
As you can see, CDs can offer some degree of flexibility and have better returns than a standard savings account. If you know you won’t need the money before the maturity date yet you don’t want to invest for the long term in real estate or the stock market, CDs might be a good option for you.
Article written by Amanda