How Does a Certificate of Deposit or CD Work?

A Safe Way to Earn More

Growing money
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Certificates of deposit (CDs) are among the safest investments out there. They’re available from banks and credit unions, and they tend to pay more than savings accounts and money market accounts. The main drawback to CDs is that you have to lock your money up in order to earn the higher interest rate.

The Basics

CDs are a form of time deposit. In other words, you promise to keep your cash with the bank for a specified amount of time (6 months, 18 months, or a few years).

In return for that promise, the bank agrees to pay you more than you’d get from a savings account – you get a higher annual percentage yield (APY). Why does the bank pay more? Because they know they can use your money for longer-term investments like loans, and you won’t come asking for it next week.

When you open a CD, you’ll choose how long you want to keep your funds locked up. This time period is called the term, and common terms include 6, 12, 18, and 60 months, although other terms are available.

In general, you’ll earn more when you go with longer terms. But longer terms aren’t always the best idea. For starters, you might need your money before the term ends. If you pull your funds out early (which is usually possible, but in rare cases banks and credit unions have denied these requests), you’ll have to pay an early withdrawal penalty. That penalty will eat into any interest you earned – and it might even eat into your initial deposit – so you’re better off keeping your money in a savings account if you’re going to need it soon.

At some point, your CD will mature – the term will end and you’ll have to decide what to do next. As you approach the end of the CD term, your bank will notify you that your CD is about to mature, and they’ll give you a few options. If you do nothing, in most cases your money will be reinvested into another CD with the same term as the one that just matured.

If you were in a 6 month CD, they’ll put you into another 6 month CD. Note that the interest rate may be higher or lower than the rate you were previously earning – there’s no guarantee that you get to keep the rate.

If you want to do something besides reinvest into a new CD, you need to let your bank know before the renewal deadline. They can transfer the funds into your checking or savings account, or you can switch to a different CD with a longer or shorter term.

How to Start Using CDs

To put money into a CD, simply contact your bank or credit union. Let them know how much you want to move and how long you’d like the term to be. You can do this over the phone, and you can also provide instructions online. Be sure to ask plenty of questions about early withdrawal penalties and alternative terms (that might have more attractive interest rates) – or read through that information online.

Once you move money into a CD, you’ll see a separate account on your statements or online dashboard.

Is a Longer Term Better?

Longer term CDs always seem more attractive than shorter term CDs because they pay more.

However, they’re not always the best choice. Take a 5 year CD for example: it’s difficult to guess whether or not you’ll need that money in 5 years. What’s more, if you buy a CD when interest rates are low, you may lock yourself into a low-paying CD for the next 5 years – what if interest rates (and therefore CD rates) rise in a year or two? You might be better off using shorter term CDs that renew with higher rates.

If you’re interested in using longer term CDs, it’s a good idea to use some strategy. The most common strategy CD investors use is the ladder: buy several different CDs with different terms – that way you’ll always have some money coming available, and you won’t lock all of your money into a low-paying CD. For more details, read about CD ladders.

Another way to protect yourself is to use CDs that offer flexibility. They might allow you to:

  • Get out early without paying any penalty, or
  • “Bump up” your interest rate to a more current (higher rate)

As you might imagine, the more flexible a CD is, the lower the starting interest rate (there’s no free lunch).

CD Safety

What makes CDs safe investments? They are very similar to cash in your savings or checking account. Assuming your deposits are FDIC insured (or covered under NCUA insurance if you use a credit union), you’ve got a government guarantee: the US government will make you whole if your bank goes belly-up. That’s about as safe as you can get.

With any investment, you need to choose between risk and potential reward. CDs fall on the low risk, low return end of the spectrum. They’re a great place to keep cash that you can’t afford to lose because you intend to spend it within the next few years. If you won’t need the money for several decades, evaluate other investments as well as CDs for your long-term goals.

If you’re going to invest in CDs, you’ll naturally want to earn the highest rates possible. For any given CD (a 6 month CD for $1,000, for example) different banks and credit unions will offer different interest rates. So what can you do to juice up the return on your cash (in terms of the APY that you earn)? You can put your money where it’s likely to get the best yield, use strategies and products that help improve your chances, and shop around.

How Long?

You already know that longer term CDs usually (but not always) pay more than shorter term CDs, so does that just mean you should go with long-term CDs to earn more?

Not necessarily. In addition to having your money locked up when you need it, sometimes longer term CDs cause you to miss out when interest rates rise. If you receive a lump sum of cash that you want to put in CDs, the return you get depends on how high interest rates are on the day you buy your CD. If interest rates are especially low, even long-term CDs will pay very little – and you’ll lock in that meager return for several years to come.

It’s impossible to time anything just right, but it’s worth paying attention to what interest rates are doing and making some guesses about what you think might happen. You might guess wrong, so be sure to hedge your bets. A good way to do this is to use a CD laddering strategy to spread out your maturities.

If you believe that interest rates are high and that they’re only going to drop, long-term CDs might make sense. Just keep in mind that it’s impossible to predict the future.

Fancy CDs

CDs come in a variety of forms these days. Traditionally, you could describe a CD as follows:

  • It has a fixed rate that does not change
  • You will pay a penalty if you cash out early

Now, you have more options. Liquid CDs (or “no penalty” CDs) allow you to pull your funds out at any time without paying an early withdrawal penalty. This allows you to be nimble and move your funds to a higher paying CD if the opportunity arises.

If you can avoid paying a penalty, why wouldn’t you always use liquid CDs? That flexibility comes at a price: you’ll earn less on your deposits. Liquid CDs pay lower interest rates than CDs that you’re locked into, and that makes sense if you look at things from the bank’s point of view. Now, if you’re confident (and you end up being correct) that rates will rise soon, earning a little bit less for a short period of time might be worth it if you can switch to a higher rate later.

If you’re thinking of using a liquid CD, make sure you understand any restrictions. While you enjoy some flexibility, the product might not be as simple as you’d think. Sometimes you’re limited to when you can pull funds out, and there might be restrictions on how much you can take at any given time.

Bump-up CDs provide a benefit that’s similar to liquid CDs: you don’t get stuck with a low return if interest rates rise after you buy a CD. If you’ve got a bump-up CD, you get to keep your existing CD and “switch” to a new, higher rate (assuming your bank is offering higher rates). This is an option, and typically you have to inform the bank that you want to bump your rate higher. If you do nothing, they’ll assume you’re sticking with the existing rate – perhaps you’re waiting for rates to go higher (you usually only get one bump-up per term), or perhaps you haven’t noticed that you can earn more.

Bump-up CDs, like liquid CDs, start out paying lower interest rates than standard CDs. If rates rise enough, you can come out ahead; if rates stay stagnant or fall, you would have been better off with an old-fashioned CD.

Brokered CDs are another alternative. Sometimes they offer better rates, and sometimes you’re better off going straight to your bank or credit union. Brokered CDs are CDs sold in brokerage accounts. Instead of opening an account at a given bank and using a CD there, you can buy brokered CDs from numerous banks and keep them all in one place. That gives you some ability to pick and choose, but brokered CDs come with additional risks. For starters, you’ll want to make sure that any bank you’re considering is FDIC insured – CDs without insurance are likely to pay more (not surprisingly) so they may get your attention. In addition, getting out of a brokered CD early can be challenging. For more details, read How Brokered CDs Work.

Shop Around

If you want to save with a CD, you can certainly do it wherever you already have checking and savings accounts. However, you might do a little better if you shop around. Whether or not it’s worth spending time shopping will depend on how much extra you can earn (there’s no point in opening a new account if you’ll only earn an extra $7 over a year – your time is worth more than that).

To find good deals, look for advertised “specials” from local banks. Those might appear online or in local news publications. When banks and credit unions want to attract deposits, they offer especially high interest rates to get your attention. As always, remember that if something seems too good to be true, you’re probably not getting the complete story – and stick with FDIC insured products (or NCUSIF insured CDs if you’re using a credit union).

Look for deals at internet banks as well. Since online-only banks don’t have the same overhead as brick-and-mortar institutions, they might be able to offer higher rates (that’s just one of the reasons for banking online).

Finally, don’t be afraid to ask your banker for a better rate. Especially if you work with a small bank or credit union and do significant business with them, you might be able to earn a little more.

If CD’s are sounding good to you, let’s take a step back and look at some pitfalls.

First, you need to lock your money up. If you want to get it back before the CD matures, remember that you may have to pay a penalty. Ask your bank exactly what the penalty will be, and find out if you qualify for a waiver of the penalty.

Next, if safety is important to you, make sure that your bank is FDIC insured. Look for the phrase “Member FDIC” or the FDIC logo.

Credit unions are not FDIC insured, but they are insured by the National Credit Union Administration (NCUA) – which is just as good as the FDIC – so they won’t show up in the FDIC’s database. NCUA insurance is backed by the US government, just like FDIC insurance, and the coverage limits are equivalent.

Finally, remember that because the risk level is relatively low, your reward might also be relatively low. There are various types of risk, including the risk of losing your money and the risk of losing purchasing power (as inflation eats away at the value of your savings).

CD investors have a relatively low risk of losing their money. However, using CDs over the course of several decades means you're exposing yourself to other risks (although there's nothing wrong with keeping and emergency fund in cash). Long-term investors should at least familiarize themselves with the alternatives and risks associated with other investments.

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