Certificate of deposit: What is a CD?

Photo illustration to accompany article on certificates of deposit (CDs) ©Getty Images

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Certificates of deposit, or CDs, operate on a basic tradeoff — in exchange for locking up your money for a fixed amount of time, you get a higher interest rate.

Following the Federal Reserve’s decision in early 2020 to reduce benchmark rates to near-zero in response to the coronavirus pandemic, that difference today is marginal — you may even find higher interest rates on regular savings accounts. But when the economy moves toward a higher-rate environment in the future, CDs can be an extremely lucrative way to earn added interest on your savings.

What Is a CD?

When you deposit money into a CD, you are effectively leaving your money there for a predetermined period of time, in exchange for a set interest rate. You can find CDs that range from just a few months to more than 10 years, so it’s important to ensure upfront that you won’t need access to the money before the end of your term. Withdrawing early can carry penalties. 

Like savings accounts, you can rest assured that your money is safe, no matter what happens to the markets or your financial institution. CDs worth up to $250,000 are federally insured at banks by the FDIC, and up to the same amount is insured by the NCUA if you open your CD with a credit union.

Here’s a more in-depth look at factors you should consider before opening a CD and how you can best use these products in your financial plan.

When to Choose a CD

The best time to open a CD is when you can secure the best rate. If you open a CD during a period of high interest, you can lock in a higher interest rate than you’ll be able to access when rates are lower, as they have been over the past year. 

“People who locked in a three-year CD [in 2019] are very happy, because current rates are much lower,” says Mark Wilson, CFP, founder and president of MILE Wealth Management in Irvine, California. “If they locked it in at, say, 3%, that looks really good compared to what they could get today. There’s some times where locking it in benefits you.” 

CDs can also make a great choice when you’re looking for added security. Since CDs are less accessible than traditional savings accounts, you won’t run the risk of dipping into funds you’ve reserved for a specific purpose just because you need some extra cash. In that way, you’re securing your cash even from yourself. 

And because they’re federally insured deposit accounts, as long as you maintain your agreement until the end of your CD term, you won’t lose any money on your deposit.

How Does a CD Work?

CDs are a type of savings account with a fixed interest rate and term, or time period. When you open a CD, you agree to leave your money in the account for the length of the term in exchange for earning interest at the agreed-upon rate. 

Here are a few factors that can help you choose the right CD:

Term

CD terms vary and can affect your total interest earned. The purpose of the money you deposit into your CD can help inform what term lengths you should consider. If it doesn’t have any specific purpose, think through the length of time you’d be most comfortable not having access to those funds.

“Maybe you want to buy a house in a year or two,” says Chantel Bonneau, CFP, wealth management advisor at Northwestern Mutual. “But when you buy a 10-year CD, you’re basically promising them that you’re not going to touch it. You want to look at the term and be very confident that you’re not going to want that money in the interim.”

Interest rate

With today’s climate leaving interest rates near-zero, CD interest is not much different from what you’ll find among high-yield savings or money market accounts.

In a higher rate environment, you’ll likely earn more in a CD than in a savings account. Still, if you’re looking for the highest rate of return, you won’t earn it through CDs. They may offer higher rates than other deposit accounts, but riskier investments in stocks and bonds will offer higher potential returns — without the security.

And remember, terms and interest rates are closely tied when it comes to CDs. “Typically, the longer the term, the more benefit you get from locking up your money,” Wilson says. “A three-month CD’s return is going to be lower than a three-year CD.”

Penalties

In a worst-case scenario, it is possible to access your money before the CD reaches maturity, but you’ll face a penalty for doing so. 

Penalties vary depending on type of CD and institution, but may include all or some of the interest you’ve earned up to that point in the CD’s term or even a portion of your original deposit.

However, there are liquid options available through no-penalty CDs. You’ll still lock in a fixed rate and may be allowed one-time or partial withdrawals, but you likely won’t earn as high a rate as a traditional CD.

CD vs. a Savings or Money Market Account

The main differences to consider when choosing between CDs, high-yield savings accounts, and money market accounts are liquidity and interest.

CDs are the least liquid option. Once you put your money in a CD, you’ll generally face a penalty if you need to withdraw before the CD matures. You’ll also need to deposit your full principal upfront; typically, you can’t add money to a CD throughout the term. 

Savings and money market accounts, on the other hand, allow you to add or remove your principal at any time. You may be subject to withdrawal limits within certain time periods, but your money remains highly liquid as long as your account is open.

In exchange for giving up liquidity, though, you may potentially earn higher interest with a CD. Long-term CDs, especially, can help you unlock the most competitive interest rates among these deposit accounts.

However, CDs aren’t as lucrative today as they were in the past. In fact, today’s CD rates are comparable to both high-yield savings and money market account APYs. While rates remain low, it can make more sense to store your savings in a savings or money market account so that when rates do increase, you’re not locked into a rock-bottom APY.

Depending on your goals, you can also use a combination of these accounts.

If you’re just starting to save — maybe you’re building up an emergency fund or making contributions toward a down payment on a new home — stick to a high-yield savings or money market account to which you can make automatic transfers or regular contributions.

Then, once your safety net is in place, consider using CDs to bolster your financial plan.

For example, if you’ve saved 12 months’ worth of expenses in an emergency fund, but you’re confident you’d feel comfortable with just six, consider moving the extra to a long-term CD with an interest rate boost. Or if you’re nearing retirement age and have some extra cash that you’d like to save for a down payment on a second home in five years, park it in a CD to ensure you won’t spend it or lose any of its value in a more volatile investment account.

Where to Open a CD

You can open a CD at either a traditional or online bank. Make sure the financial institution you choose is a member of the FDIC or NCUA, so your money is federally insured. 

Beyond that, the best place to open a CD may depend on a number of factors related to your personal goals, including the interest rate, term, minimum deposit, penalties, and other details about the CD.

If you’re looking for more information on where to open a CD, our list of best CD rates is a great place to start.

Are CDs Safe?

CDs are among the safest accounts you can use to save money. 

As long as your bank or credit union is an FDIC (for banks) or NCUA (for credit unions) member, up to $250,000 per account is federally insured in case of bank failure. Both brick-and-mortar as well as online banks are federally insured.

CDs are also safe from market fluctuations. These are deposit accounts, which means your savings won’t fluctuate like investments in a brokerage account made up of stocks and bonds. Instead, you’re guaranteed the principal amount deposited, plus interest accrued, as long as you meet the term requirements.

What Types of CDs Are There?

There are many different types of CDs, each with different terms, interest, penalties, and other requirements. Here are a few common CD types:

  • Standard CD: A traditional CD with a fixed term and fixed interest rate. You deposit a lump sum in upon opening, which you’ll receive back (with interest accrued) when the CD reaches maturity. If you take your money out early, you’ll incur a penalty.
  • No-penalty CD: This type of CD allows you to withdraw your money at any time throughout the term without penalty. These CDs tend to offer lower interest rates than other types, and you may still need to meet requirements before withdrawal.
  • Bump-up CD: If interest rates rise over your bump-up CD’s term, you can request to “bump up” your CD’s rate to the rate your bank currently offers on new CDs.
  • Step-up CD: Instead of requesting a rate increase, your bank may automatically increase your CD’s interest rate to match the current market at certain intervals throughout the term with this CD type.
  • Add-on CD: Many CDs require minimum deposits to open, and don’t allow contributions throughout the term. With an add-on CD, you can deposit more cash into the CD as it approaches maturity, though you’ll likely be limited to a certain number of add-on contributions.

How are CD Rates Determined?

Like all deposit accounts, CD rates are determined by the banks that issue them but are largely based on the federal funds rate. Generally, longer-term CDs will offer higher interest rates, while short-term CDs offer lower interest rates. 

When the Federal Reserve lowers interest rates, banks follow suit by offering lower yields on their consumer deposit accounts — including savings, money market accounts, and CDs. When rates are falling, it can make sense to lock in a competitive interest rate with a CD. But tying up your cash in a low-earning CD won’t be as lucrative if you expect rates to rise before your CD matures.

Pros and Cons of CDs

Pros

  • Potentially higher interest rates than traditional savings or money market accounts

  • Ability to lock in a higher interest rate during a falling rate environment

  • Safety and security of your deposit. You won’t have to worry about market volatility, and deposits are FDIC-insured

Cons

  • In a low interest rate environment, the margins between CD interest and traditional savings are not high

  • You lose access to your money for the full term of the CD, or face a penalty for withdrawal

  • You cannot make regular contributions to build up savings, and instead must deposit a lump sum at the start of your CD’s term

  • Know what type of CD you’re considering. Some types carry more risk than traditional CDs

  • Your interest earnings are taxable income (this is true for any deposit account)

Is a CD Worth It?

When interest rates are high, CDs can provide highly competitive rates on even relatively short term products. In today’s environment, though, many CD interest rates are comparable to, if not lower than, rates on more liquid savings and money market accounts.

And while higher rate environments may offer incentive to lock up money in a long-term CD for even more interest, those margins aren’t as lucrative today either. For many people, the small difference in interest likely won’t justify losing the cash flow.

“I don’t think you’ll be penalized by waiting or having a bit more liquidity,” Wilson says. “The differences are very small today, and that’s just because the yield curve is flat. But there are times when it’s very steep and going from one year to three years to five years to 10 years could be a really big difference in the yield.”

Bonneau recommends crunching numbers to get a better sense of the value proposition. If you have $20,000 that you don’t need to access for 10 years, for example, the 1.5% you’ll earn by putting it in a CD will be about $300.

“You need to always be evaluating that trade-off,” Bonneau says. If that amount of money earned means a lot to you, you may weigh it heavily. 

“If it doesn’t mean that much, then maybe it’s not worth locking it up,” she says. “The weight of that decision means different things to different people based on their circumstances. Sometimes people get wrapped up in the 1% but they forget what that actually means in dollars.”

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