A certificate of deposit, or CD, is a savings vehicle with a fixed deposit held for a fixed term and yielding a fixed rate of interest.
Learn how a CD works through an example, its pros and cons, and alternatives to determine whether to incorporate it in your savings strategy.
What Is a Certificate of Deposit?
A CD is a type of savings account offered by banks and credit unions that contains a fixed sum of money and is held for a fixed period of time ending on the "maturity date," during which time your money typically earns interest at a fixed rate expressed as an annual percentage yield (APY). This makes the product an excellent way to save for a financial goal a set number of years in the future. However, you'll typically be charged an early withdrawal penalty if you take money out of the CD before the maturity date.
- Alternate name: time deposit
Some banks offer variable-rate CDs whose rates change over time. Among these CDs, some offer a multi-step structure whereby the rates change according to a predefined schedule, whereas others attempt to yield interest at a rate that tracks a certain market index.
How a Certificate of Deposit Works
A CD works like a savings account in the sense that you earn interest in exchange for holding your deposits at a financial institution. The difference is that once you deposit the funds in the CD, they are, in effect, under lock and key; you can't withdraw the principal or interest without facing an early withdrawal penalty.
When the CD has matured (which could be three months or potentially five years away), your bank or credit union will typically offer you a grace period to decide whether to renew the CD or withdraw the funds. If you opt to withdraw the funds, you'll receive the principal and the interest that accrued. However, if your financial institution has an automatic renewal feature and you did not turn off that feature, the funds will automatically be rolled over to a new CD when the grace period ends.
For example, let's say that you want to grow a small fund for a trip in five years. As you know you will need the funds in five years but don't need to access them until then, you open a CD at your local credit union with a five-year term and an APY of 2% with daily interest compounding. You deposit $1,000 and turn off the automatic renewal feature. You patiently wait until the maturity date five years later and then opt to withdraw the funds from the account, which now amount to $1,104.08.
Your deposits in a CD are federally insured for up to $250,000 per bank, per depositor, through either the Federal Deposit Insurance Corporation (FDIC) insurance for banks or National Credit Union Share Insurance Fund (NCUSIF) insurance for credit unions.
Types of Certificates of Deposit
You have several options when it comes to CDs:
- Traditional CDs: These are regular CDs that yield a fixed rate of interest for a fixed period of time and come with an early withdrawal penalty.
- High-yield CDs: These are virtually identical to traditional CDs but offer above-average rates of interest in exchange for longer CD terms and larger minimum deposits.
- No-penalty CDs: These accounts allow you to withdraw funds from the CD after a certain period without incurring an early withdrawal penalty, giving you easier access to your money than traditional CDs.
- Bump-up CDs: These CDs allow you to ask the bank to increase your rate once during the CD term to the current rate on offer to take advantage of rising interest rates. They're a great way to guard against the inflation risk posed by CDs.
- Step-up CDs: These are similar to bump-up CDs except the financial institution increases your rate at designated intervals instead of having you direct it to do so.
Pros and Cons of Certificates of Deposit
Attractive, typically fixed rate of return
Variety of term lengths
Ability to spread deposits over multiple CDs
Lower yields than some investments
The advantages of CDs include:
- Higher, typically fixed rate of return: You're generally guaranteed to get the rate on offer when you open the CD, which is particularly advantageous if interest rates are expected to fall in the future. Moreover, the APY is usually higher than you can get with a traditional savings account or a money market account.
- Safe investment: CDs are considered one of the safest places to put money as FDIC or NCUA insurance guarantees your deposits. This wouldn't be the case if you were to put your money in stocks, bonds, or mutual funds, which are investment products and thus aren't FDIC-insured.
- Variety of term lengths: You can find CDs with terms of as little as one month to as long as 10 years, though terms of three months to five years are more common. This range allows you to save for a variety of goals in the short or medium term.
- Ability to spread deposits over multiple CDs: If you build a CD ladder—that is, open multiple CDs with different maturity dates—you can lock in high rates of return on more than one CD and avoid having to wait until a single date in the future to free up your money.
The drawbacks of these savings vehicles include:
- Early withdrawal penalties: If you have to break the CD, you'll usually have to pay a penalty that depends on the CD term but usually represents a certain number of days or months of interest. These penalties can be substantial, but even when they're not, they ultimately eat into your interest gains.
- Inflation risk: The fixed rate on typical CDs means that your returns may not keep up with inflation, particularly during periods of higher-than-average inflationary. Your real returns would thus fall over time.
- Lower yields than some investments: Although your money will be safer in a CD than in the market, the opportunity cost is the higher rate of return you might earn by investing in a more aggressive investment like a stock or stock fund.
Avoid dipping into your CD and incurring penalties by having a solid emergency fund in place or using a CD ladder as a savings tool.
Alternatives to Certificates of Deposit
If you seek the growth of your deposits but are leery of buying individual stocks, consider choosing mutual funds instead of CDs. They spread the risks over a wide variety of stocks, bonds, or other securities to reduce your risk but still give you a higher rate of return depending on the underlying assets. A good financial adviser can help you find funds that reflect your risk tolerance when investing.
If you seek liquidity but don't want to open a no-penalty CD, consider a savings account. A traditional savings account may offer a lower APY than a traditional CD, but you can make withdrawals without fees, up to limits. You can also choose online savings accounts for higher rates.
Is a Certificate of Deposit Worth It?
A CD is a good option if you know you'll be using the money you intend to deposit within a specific period of time and won't need to access it immediately. They're relatively low-risk savings tools with moderate returns that can help you reach your financial goals.
Generally speaking, CDs are most appropriate for short- to mid-term financial goals. Although your rate of return increases as the term length increases, it may not be high enough to warrant locking up your money for several years. If your savings goal is more than five years in the future, consider investing in a mutual fund. While a mutual fund is riskier, you will get a substantially higher return. If you need to maintain access to the funds, a savings account is another viable option.