A certificate of deposit, better known as a CD, is a secure, low-risk way to set aside – and earn interest on – a chunk of savings for a pre-determined period of time. Historically, CDs have offered a better opportunity to earn more interest than a traditional savings account. However, you’ll have to pay a penalty if you access your funds before the CD reaches its maturity date.
But what exactly is a CD account and how does it work? Here are some key things to know before deciding whether a CD is appropriate for your savings needs.
What Is a Certificate of Deposit?
CDs are savings products offered by banks and credit unions that allow you to save money and earn interest at a fixed rate for a set period of time. Interest rates and CD maturity terms are established by the bank offering the CD. It’s important to note that you can only access your savings once the term ends. Otherwise, you’ll have to pay a penalty.
Fixed rates provide a clear and predictable rate of return on your deposit. Since market rates tend to fluctuate, a CD can be a great way to lock in an interest rate for an extended period.
CDs are a nearly risk-free way to grow your savings because they don’t rely on stock market investments and may be FDIC insured up to $250,0001.
How Does a Certificate of Deposit Work?
CDs offer a way to “set and forget” your savings while earning more interest than you’d typically earn in a traditional savings account or interest-bearing checking account. The interest rate you’ll get with a CD depends on the financial institution, which term options you choose, and current market rates. Here’s the gist of how CDs work:
1. Choose a term. CD terms generally range from six months up to five years. It’s up to you to choose the term that makes the most sense for your financial situation. If you need access to the funds for a large purchase next year, it may make sense to keep the money safely tucked away in a CD for 12 months. However, if you plan to purchase a home in five, you may opt for a 60-month term instead.
2. Deposit your principal. When you choose to open a CD, you’ll have to deposit an initial balance into the account, known as the “principal.” Some banks require a minimum deposit to open a CD account, but not all.
3. Earn interest. Your principal will earn interest at the fixed rate established when you opened your account. Interest is typically credited to your account and compounded, meaning that the interest you earn is added to your principal, and that new total balance earns interest, and so on. However, your CD issuer may also let you choose to have each interest payment sent to you via check or transferred directly into a different account like a checking account or high-yield savings account. While interest won’t compound, you’ll get access to your interest payouts in monthly, quarterly, or yearly intervals, depending on your account’s specifics.
4. Wait for your CD to reach maturity. Now you get to “set it and forget it.” Your CD balance will earn interest in the background while you wait for your CD to reach maturity – the length of time you agreed to leave your funds deposited. Just remember that you can’t access your funds before the term is up without paying a penalty. This can be a good way to encourage the discipline needed to let your savings grow.
5. Renew or withdraw. Once your CD reaches full maturity, your account will either close and you can withdraw your principal plus all earned interest, or your CD account will be renewed with similar terms and the current prevailing fixed interest rate. If you choose to renew, you may be able to add additional funds to the principal to increase the amount of savings earning interest.
How to Open a CD Account
The exact steps to open a CD account depend on the financial institution. But you can usually apply online, by phone, or in person if the bank has a brick-and-mortar location. You’ll need the same basic info as opening a bank account, including:
- Social Security number.
- Home address.
- Date of birth.
- Phone number.
Once you gather your information, you can submit an application to open a CD account. If approved, you’ll be able to select your maturity term, lock in your fixed interest rate, and deposit your initial principal.
Benefits of Investing in CDs
CDs can be a great way to earn interest on your savings, but like any savings method, they have their own advantages and disadvantages. Here are some factors to consider to help you decide whether opening a CD account is right for you.
A CD may be right for you if:
- You have a lot of money in your checking account or standard savings account. Transferring a sum from one of those accounts into a CD may help you earn more interest on the funds you aren’t using.
- You want to save money but don’t need to access funds quickly.
- You want a low-risk way to get better returns than a traditional savings or checking account.
- You expect market interest rates to decrease and want to take advantage of a CD’s fixed interest rate.
Risks of Investing in CDs
A CD may not be worth it for you if:
- You don’t yet have a liquid emergency fund in a traditional savings or high-yield savings account, since CD accounts will lock up your funds for a while. Ideally, experts recommend setting aside three-to-six months’ worth of expenses to cover the basics in case of job loss or other emergencies.
- You want to build short-term savings to buy a new car, home, or make repairs. In that case, a high-yield savings account may be a better option.
- You’re looking for a way to get a higher return on investment, even if more risk is involved.
What Factors Affect CD Rates?
The interest rates of CDs may be influenced by several factors, including the federal funds rate, which the Federal Reserve sets, the term length you choose, and the amount of money you’re willing to invest in the CD. When you commit to putting more money in a CD over a longer term, you may be able to get a more favorable rate than if you deposit a smaller amount for a shorter term.
CD rates can climb alongside the federal funds rate during inflationary periods, and they can also fall as quickly as interest rates do. That’s why experts recommend keeping tabs on the current interest rate environment and locking in a CD when it makes sense based on rates and your unique savings timeline.2
Is a CD a safe investment?
Some people are wary of using long-term CDs because they’re hesitant to have their money tied up for an extended period. A solution for this is to create a CD ladder. With a ladder approach, instead of investing $50,000 in a single CD for a five-year term, you’d choose five separate CDs with $10,000 each for terms of one, two, three, four, and five years.
Then, at the end of year one, when the first CD reaches maturity, you could choose to use the money for other purposes or purchase a new five-year CD with the principal and interest, adding another rung to your ladder. This approach allows you access to money on yearly intervals instead of having cash tied up for five years.