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What Is a CD (Certificate of Deposit)?
February 24, 2017
A CD, or certificate of deposit, is a type of savings tool that can offer a higher return on your money than most standard savings accounts. Better yet, there isn t much risk involved, and CDs typically don t have monthly fees.
But before committing to a CD — and “commit” is the operative word, as you’ll see — you should know how they work and determine whether one will fit your needs.
What is a CD?
A CD is different from a traditional savings account in several ways. A CD is what s called a timed deposit. With a savings account you can deposit and withdraw funds relatively freely, but with a CD, you agree to keep your money there for a set period of time, called the term length. Term lengths can be as short as a few days or as long as a decade, but the standard range of options is between three months and five years.
Generally speaking, the longer the term length — the longer you commit to keeping your money in the account and thus with the bank — the higher the interest rate you ll earn.
As a reward for parking your cash with them for a longer time, banks and credit unions often offer higher CD rates than their savings account rates. CD rates are quoted as an annual percentage yield, or APY, which considers the frequency with which interest is paid on the account (aka the compounding period). Banks can choose to compound rates on a yearly, quarterly, monthly or even daily basis.
The average rate on a three-year CD at a bank currently stands at 0.50%. However, many credit unions and online-only banks offer certificates with rates above 1%.
To find the highest rates currently offered by banks and credit unions, check out NerdWallet s CD rates tool .
CD early withdrawal penalties
If you end your commitment early by withdrawing the money before the CD matures. you ll likely be charged a penalty. It varies, but typically you ll give up three to six months’ worth of interest accrued. Consumers should take note of any such penalty on a CD before choosing to withdraw early. The loss of interest may outweigh the benefits of taking the money out.
CDs at most banks are backed by the Federal Deposit Insurance Corp. or FDIC, for up to $250,000. At credit unions, share certificates are insured up to the same amount through the National Credit Union Administration, or NCUA. Some state-chartered credit unions may operate with private insurance. This insurance does not cover penalties incurred by withdrawing funds early.
How can you tell if your bank or credit union offers insurance? All institutions with federal backing must display FDIC or NCUA signs at teller windows and on their websites. If they do, coverage is automatic. You don t have to apply for your money to be insured.
Types of CDs
CDs typically come with a fixed term and a fixed rate of return. But depending on where you bank, you may have access to a few other varieties.
- Variable-rate CD: This is tied to the prime interest rate, Treasury bills, a market index or some other driver — it varies by institution — and lets the depositor benefit from potential future rate increases (or the opposite).
- Low/no-penalty for early withdrawal: In exchange for allowing you greater access to your money, these certificates (also called liquid CDs ) usually provide lower rates of return than traditional CDs and require you to maintain a minimum balance.
- Callable CD: This might come with a higher interest rate than a regular CD, but the bank retains an option to unilaterally shorten the terms — to, in effect, say at any point, We re not getting as good a deal anymore, so let s end this. Before you get drawn in by the higher rate, read the fine print to see if the CD is callable.
- Jumbo CD: This is essentially the same as a regular CD but with a very high minimum balance requirement (upward of $100,000) as a tradeoff for higher rates.
- IRA CD: This is a regular certificate that is held in a tax-advantaged individual retirement account, or IRA.
Some savers might want the higher rates of a three- to five-year certificate, but are wary of tying up their money for such a long time. That s where the practice of laddering can come in handy. You invest proportionally in a variety of term lengths. Then, as each shorter certificate matures, you reinvest the proceeds in the CD with the longest term.
Let s look at an example. Say you have $10,000. With that cash you invest $2,000 apiece in one-, two-, three-, four- and five-year CDs.
At the end of the first year, when the shortest-term certificate matures, you put that money into a new five-year CD. The next year, you reinvest the funds from the matured two-year certificate in another five-year CD. And so on.
Repeat the process until you have a five-year CD maturing every year. At that point, you’ll have the flexibility of cashing out one certificate a year without facing early withdrawal penalties.
Low risk, some reward
Investing in a certificate of deposit is not the quickest way to grow your money, but neither is it terribly risky. Indeed, a CD with a decent rate can play an important role in your overall savings plan.
By choosing the right type of CD, taking advantage of a laddering strategy and not incurring withdrawal penalties, you can earn a solid return on your money. Better yet, you ll benefit from the security of having your savings backed by the federal government.
Verified Feb. 24, 2017.