Certificate of Deposit (CD)
Among the deposit accounts offered by financial institutions is the certificate of deposit or CD.
Used correctly, a CD can help you earn more interest, keep your money safe and manage your cash flow.
The key to using CDs correctly is to learn how CDs work, where to buy CDs, and how to plan the term length to coincide with your financial goals.
Of course you should ask "How much interest will I earn on a CD?"
But the better way to evaluate CDs is to look for a bank or credit union that consistently offers the best CD rates. That's because the top rates available are offered by banks that consistently offer the top rates.
What is a CD Account?
A CD account (or time deposit) is a product banks and credit unions offer that is designed to pay a fixed interest rate for a specific period of time.
Certificates of deposit are different from demand deposit accounts that allow you to withdraw your funds at any time. To earn the higher rate offered on a CD account, you are required to commit to a term length of a few months to five years.
So there's a trade-off: In return for leaving your funds on deposit until the CD matures, most CDs allow you to lock in your interest rate so it's not subject to the frequent interest-rate changes typical of a traditional savings account.
And while most savings and money market accounts provide liquidity options unavailable in a CD account, many investors are willing to keep funds in a CD investment that earns better annual percentage yields if the money isn't needed in the short term.
How Do CDs Work?
Think of a CD like a contract. You agree to put a certain amount of money into the CD account up front. After a preset period of time, you get your money back plus interest.
That interest is usually a fixed interest rate that is agreed upon when you open a CD. There are also certificates of deposit whose rates might vary based on things like stock market performance, but these are not very common.
Even CDs with variable rates have a set formula that is used to determine what they will pay when the CD matures. In short, when you open a CD, you are agreeing to a specific level or formula for how interest will be paid for that preset amount of time.
CDs are designed to pay the interest earned on the maturity date, so they do not pay regular interest from month to month the way a savings account does. While interest accrues on your behalf - meaning that it is credited to your account - you don't have access to that interest until the end of the CD term.
If you withdraw your funds before the maturity date, you typically have to pay an early withdrawal penalty.
Because of how CDs work, there are three factors to consider before you open a CD:
- The term, or the length of time for which your money will be committed to the CD.
- The interest rate, or the formula for how interest will be determined over the CD's term.
- The early withdrawal penalty, which is a fee you could be charged for accessing your money before the CD's term is up.
Can You Lose Your Money in a CD?
If used correctly, you can't lose money in a CD.
Certificates of deposit that are issued by FDIC-member banks are covered by insurance from the Federal Deposit Insurance Corporation. This insurance covers you for up to $250,000 in deposits at any one bank.
However, if you're not careful how you use your CD account, it is possible for you to lose money. It's helpful to explore how this can happen so you know what to avoid.
Three ways to lose money in a CD
- No FDIC (or NCUA) insurance coverage
If your CD investment is at a bank or credit union that fails, you could lose your money. Only financial institutions that are members of the FDIC or National Credit Union Administration (NCUA) have insurance coverage that protects your funds.
- Inadequate FDIC (or NCUA) insurance coverage
If your total deposits across all accounts at any one bank exceed the $250,000 insurance limit of the FDIC or the NCUA, you could lose your money.
- If you tap into your CD early
If you withdraw your money before the fixed term is up, it is possible that the early withdrawal fee might exceed the interest you have earned, so you would get back less than you had put in.
These situations can be easily avoided. You just have to do a little planning up front to make sure you choose an FDIC-member bank and a CD term that's not too long for your needs.
Are CDs Worth It?
Every investment involves a trade-off between risk and reward. It's the nature of the beast.
So as you evaluate a CD investment, consider these questions to clarify whether the reward is worth the investment:
- What is your financial goal?
- What is the interest-rate environment?
- How will inflation affect your investment?
1. What is your financial goal?
A CD investment is compatible with many financial goals that involve shorter time horizons, such as:
- Saving for the down payment on a house
- Budgeting for expenses in college
- Managing cash in retirement
People that require funds to be available in the near term use certificates of deposit to protect against wide swings in the value of their investment. Even though better returns can be found with stocks and bonds, CDs pose little risk that you would lose your principal if they're insured by the FDIC.
2. What is the interest-rate environment?
With a CD investment, you are locking up your money for a set period of time; but, in return, you get a fixed interest rate.
Yes, savings and money market accounts offer more liquidity - you can withdraw money at any time - but the interest paid on these accounts is often much less than on five year CDs, for example. That's because liquidity has value, but it's also because banks and credit unions can change the interest rate on these accounts at any time. It is not fixed.
There's a certain value to locking in an interest rate for the length of a CD's term. Doing so protects you from falling interest rates over that period. When you open a CD account, you know what the interest rate will be and what you'll get out of it.
3. How will inflation affect your investment?
It's important to know how your investments are performing against inflation. That's because, over time, inflation can compound and make the return on your investment worth less.
To make sure the reward of a CD is worth the commitment of time, it helps to get one with the best CD rates.
You can easily check whether your CD's rate is going to protect against inflation risk. Use the CD calculator to compare CD rates and see how much money you will have at the end of the CD term, adjusted for the recent inflation rate.
How Much Interest Will You Earn on a CD?
Since the interest rate on a CD is typically preset for the term of the CD, it makes shopping for CD rates especially important. Any rate advantage you can get by comparison-shopping will be locked in for months or even years to come.
CD rates are usually advertised in terms of annual percentage yield, or APY. This is the interest rate with the effects of compounding figured in.
Be sure to compare APYs before choosing a CD.
Generally speaking, the longer the CD term, the higher the interest rate. So, you should compare APYs between CDs that are of the same length.
Even among CDs with the same length, interest rates can vary a great deal. The top CD rates can actually pay hundreds of times as much interest as the lowest rates, so shopping around can really pay off.
Can You Add Money to a CD?
Because a CD's rates and conditions are set at the start of the CD's term, they don't generally allow you to add money later on.
Though you might occasionally find CDs with special features like being able to add money or adjust rates, investing in one of these special CDs often means accepting less favorable terms on the front end.
Because of this, you might be better off simply investing in a new CD when you have additional money to invest, instead of trying to add money to an existing CD.
Where to Buy CDs with the Best CD Rates
As noted earlier, CD rates vary widely.
MoneyRates.com routinely tracks and studies CD rates. The America's Best Rates Survey is designed to identify banks that consistently offer the best savings account, money market account and CD account rates.
The study shows that, as a general rule, online CDs are a good place to look for the best CD rates. On average, online CD rates are significantly higher than rates on CDs from branch-based accounts.
Since you typically put money into a CD and leave it alone for the term of the CD, there is little advantage to having your CD at a branch if it means accepting a lower rate.
Planning Your Strategy - How to Use CDs
Because CDs represent a commitment for a set length of time, you should plan ahead to get the most out of them.
Timing your cash flow
You should select a CD term that fits with your future cash flow needs. If you plan to buy a car in six months and have some money set aside for a down payment, a 6-month CD might be a good place to put that money.
In contrast, a 1-year CD might pay a little more interest, but it wouldn't meet your need to get at the cash in six months. The penalty for breaking into that 1-year CD early might more than wipe out the rate advantage of the longer CD.
So before you invest in a CD, think ahead about your upcoming needs. The better you can match the length of your CDs with the timing of those needs, the more you can reach for the highest rates available without having to pay an early withdrawal penalty.
A CD ladder is a way of owning long-term CDs without having all your money tied up for the long term.
The idea is to own a series of CDs that come due at different times. This way you have some cash becoming available at regular intervals, even while most of your money is still earning interest in other CDs.
CD laddering can also reduce the impact of interest rate changes, since you will not find yourself reinvesting all your maturing CD money at the same time.
A general theme when discussing CDs is that they involve giving up a little flexibility as to when you can access your money in exchange for earning a higher interest rate. CD laddering can be used to get some of that flexibility back while still benefiting from higher CD rates.