What Is a Certificate of Deposit (CD)?
A certificate of deposit (CD) is a specialized savings account that offers a fixed interest rate for a set period, during which the funds must remain untouched. Unlike regular savings accounts, early withdrawals from CDs incur penalties. While CDs typically yield higher interest than standard savings accounts, they involve sacrificing withdrawal flexibility.
Key Takeaways
- Certificates of deposit (CDs) generally offer higher interest rates compared to savings and money market accounts.
- CDs are considered safer and more conservative than stocks and bonds but with lower growth potential.
- Banks, credit unions, and brokerages provide various CD options.
- Top CD rates can be substantially higher than the average rate.
- Although funds are tied up for a specific term, early withdrawal options are available.
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How Certificates of Deposit (CDs) Work
Opening a CD is similar to setting up a standard bank deposit account. When selecting a CD, consider the following factors:
- Interest rate: Most CDs have fixed rates, although there are variable-rate CDs that might offer higher returns if rates increase. With a fixed-rate CD, you know the exact earnings by the term’s end, but you could miss out if rates go up after you’ve locked in.
- Term: This is the period your funds must stay deposited to avoid penalties (e.g., 6-month, 1-year, 18-month CDs). The term ends on the maturity date, when you can withdraw your funds penalty-free.
- Principal: Except for special CDs, this denotes the initial deposit amount.
- Financial institution: The bank or credit union where you open the CD sets terms like early withdrawal penalties and automatic reinvestment at maturity.
Once funded, the CD operates like a regular deposit account with statements, interest payments, and compounding interest.
Why Should I Open a CD?
CDs provide fixed, secure—often federally insured—interest rates that can exceed those of other bank accounts. Higher rates are possible for longer commitments.
Savers seeking higher returns than traditional accounts without market risks find CDs appealing.
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CDs vs. Savings and Money Market Accounts
CDs, savings, and money market accounts enable saving for specific goals or emergencies. While savings accounts allow varying balances with deposits and withdrawals, CDs require a fixed initial deposit until maturity, offering higher interest rates in return.
Opting for a CD can ensure guaranteed returns on emergency funds or other financial goals with no access needed during the term.
How Are CD Rates Determined?
CD interest rates are influenced by the Federal Reserve’s rate decisions, impacting bank costs and consumer deposit rates. The higher the federal funds rate, the more interest CD holders earn.
Federal Open Market Committee meetings every few weeks decide on raising, lowering, or maintaining the federal funds rate, affecting what banks pay savers based on CD terms.
Major rate changes by the Fed can significantly impact CD rates, creating opportunities for better returns.
Recent Interest Rate Trends
The Fed lowered rates to near-zero in 2008 to spur economic recovery during the Great Recession, holding rates until 2015. In 2022, amid high inflation, aggressive rate hikes led to tripled or quadrupled CD rates.
Consider rate movements when starting a CD; open long-term CDs before rate hikes and vice versa.”
If you are looking to open a CD, keep an eye on the Fed’s rate actions and predictions. Opening a CD before or after a rate hike can impact your future earnings. Research what each institution offers as rates can vary based on their deposit needs and financial strategies.
Are CDs Safe?
CDs are among the safest savings options due to fixed interest rates and federal insurance protection. Banks’ FDIC coverage and credit unions’ NCUA insurance ensure CD investments against bank failures.
Choosing an FDIC- or NCUA-insured institution secures up to $250,000 of CD funds if the bank collapses.
If deposit amounts exceed the insured limit, it’s wise to distribute funds across several institutions for protection.
When Is Opening a CD a Good Idea?
CDs are beneficial for savings intended for upcoming expenses like vacations or homes without market risks. They suit risk-averse individuals seeking modest growth without market volatility.
While CDs don’t match stock or bond returns, they offer stability and deter spending due to imposed penalties for early withdrawals.
Pros
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Rates are typically higher than savings or money market accounts
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Predictable rate of return minimizes risk compared to volatile stocks and bonds
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Federally insured in FDIC- or NCUA-insured institutions
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Discourages spending with penalties for early withdrawals
Cons
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Penalties for early withdrawals
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Earns less compared to long-term stocks and bonds
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Fixed rates might limit returns if interest rates rise
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Inflation can erode the value of fixed-rate investments
Where Can I Get a CD?
Most banks, credit unions, and even online banking platforms offer various CDs, allowing you to select based on your preferred terms and rates.
Find the Best CD Rates
Today, numerous online banks and credit unions provide the opportunity to compare CD rates nationwide, allowing you to select the best rates and terms available.
Make sure to research and compare rates across different institutions before opening a CD, as rates can vary significantly. Utilize online tools to simplify the comparison process.
Always Compare CDs
The most competitive CD rates often exceed the national average.
How Much Do I Need to Open a CD?
Financial institutions set a minimum deposit requirement to open a CD, with some offering higher interest rates for larger initial deposits.
While larger deposits can potentially yield higher returns, many top CD rates are accessible with modest investments, often starting at $500 or $1,000, with the majority of competitive rates available for deposits of $10,000 or more.
Jumbo CDs requiring $50,000 or $100,000 minimum deposits typically offer higher rates, but not always.
Which CD Term Should I Choose?
Selecting the right CD term involves considering your financial goals and rate predictions. Choose a term aligned with your needs or expected market interest rate movements.
Consider current and potential Fed rate changes when deciding between short- or long-term CDs. Variable-rate and bump-up CDs can be beneficial during rising rate periods, offering flexibility and potential rate hikes.
Evaluate starting rates and potential fluctuations invariable and bump-up CDs before committing.
Variable-rate and bump-up CDs usually start with lower rates compared to traditional CDs, a factor to weigh during selection.
What Is a CD Ladder, and Why Should I Build One?
A CD ladder is a strategic approach for optimizing returns and managing rate changes over time. It involves investing designated funds across multiple CDs with staggered maturation dates, ensuring access to funds at regular intervals while benefiting from higher long-term rates.
By reinvesting maturing CDs into longer-term options, like 5-year CDs, a CD ladder offers a balance between liquidity and higher returns.
Some investors opt for shorter CD ladders with faster access to funds using a mix of shorter and longer-term CDs.
Why You Should Be Open to Odd-Term CDs
Remain receptive to non-standard CD terms that institutions may offer for promotional or strategic reasons, potentially leading to higher-paying opportunities.
Atypical, unconventional term CDs such as 5 months, 17 months, or 21 months sometimes provide higher rates or special deals, contributing to better returns.
How Are CD Earnings Taxed?
CD interest earnings are taxed as accrued at regular intervals and reported to the depositor as annually earned income for tax purposes, regardless of when the funds are withdrawn. Earnings are taxed when credited to the account, not upon withdrawal.
Ensure accurate understanding of CD interest taxation, which is based on when the bank adds interest to your account, not when you withdraw CD funds.
What Happens to My CD at Maturity?
Prior to your CD’s maturation date, the institution will notify you and present options for handling the funds, including renewing the CD, transferring funds to another account, or withdrawing the funds.
- Roll over the CD to a new one closely aligned with the maturing CD’s term.
- Transfer funds to another account like savings or checking.
- Withdraw the funds either as a check or through account transfer.
Failure to provide instructions before the deadline may result in an automatic rollover or specific actions by the institution, so timely response is essential.
Late instructions might lead to undesired outcomes like rollover at suboptimal rates or penalties for delayed fund retrieval.
Should I Let My CD Roll Over?
Rolling over a CD into a similar term can be easy, but it might not maximize returns as competitive rates can vary across institutions. Shopping around before renewal is advisable for potentially better rates.
Despite convenience, rolling over a CD without comparing other options may not yield the highest returns. Exploring different institutions increases the odds of maximizing earnings.
Even if your current institution offers competitive rates, researching broader options ensures informed decisions.
What If I Need to Withdraw My Money Early?
While CDs expect funds to remain until maturity, early withdrawal is possible with penalty fees determined by the institution’s terms in the initial agreement, typically based on interest deductions for a specific period.
Evaluate early withdrawal penalties before committing to a CD, considering the impact on principal versus earned interest.
Beware of penalties that diminish your initial investment. Opt for CDs with milder penalties rather than those eroding principal for early exits.
Typically, penalties are a set number of months’ interest, varying based on the