If you’re looking for a secure way to earn modest interest, consider a certificate of deposit (CD). These savings products are a lump sum inverted for a set period of time with a set interest rate. Unlike a savings account, you can’t access the money in a CD until the term is complete without paying a fee. For that loss of liquidity, you typically earn a higher interest rate than in a savings account. Read on to understand what is a CD and when you may want to use one for your savings goals.
What Is a Certificate of Deposit (CD)?
CDs are government-backed securities that are one of the least risky investment options. CDs typically pay higher interest rates than savings accounts or money market accounts but still offer a guaranteed return.
Key characteristics of a CD are set maturity terms, ranging from as short as one month to 10 years. You’ll need to keep the money in the CD during the term or risk paying a penalty. The CD also has a set interest rate for the term.
CDs are considered low-risk as they are government-backed. You can choose certificates of deposit from most banks, credit unions and brokerage firms. If you need your money back early, you can usually exit a CD with a fee.
How Does a Certificate of Deposit Work?
A CD is a type of specialized savings account. CDs offered through banks or credit unions are FDIC or NCUA insured up to $250,000. With a CD, you place a set lump sum into the account and receive a set interest rate. You choose the term and principal amount and can shop around for interest rates.
CD terms usually range from one month to 10 years. The annual percentage yield (APY) or interest rate for CDs is typically fixed and varies based on standard market interest rates. Current interest rates are often around 4% to 5.5%. You can find the current best interest rates here. Learn more about whether CD interest rates will go up. Generally, the longer the CD term, the higher the interest rate.
Typical amounts for CDs range from $500 to $2,500 or more, but CDs are insured up to $250,000 per institution, per depositor at banks and credit unions, so you could hold multiple CDs. Many investors build a CD ladder with multiple CDs for various terms to take advantage of higher interest rates for longer terms while getting liquidity for shorter terms in case interest rates go up.
Pros and Cons of Certificates of Deposits
There are numerous advantages to certificates of deposits as one financial tool for building long-term wealth. However, they are not the best options for all financial goals. Here is an overview of the pros and cons.
Advantages of CD Accounts
The main advantages of CD accounts come down to security, guaranteed returns and higher interest rates than other savings products. With a CD from a bank or a credit union, your investment is guaranteed, even if the bank runs into financial difficulties. Likewise, interest rates on CDs are generally set, giving you greater options to earn more.
You may get charged a monthly maintenance fee on a savings or money market account, but CDs don’t have monthly maintenance fees. While not a direct advantage, you can set up CD ladders to meet your financial goals based on various terms to optimize interest rates.
Disadvantages of CD Accounts
The main disadvantage of CDs is the interest rates. While there’s a low-risk option, you could potentially get higher interest rates with other forms of investment options. That has several implications. First, in times of high inflation, the CD may barely outpace inflation. In addition, if interest rates increase significantly during the CD’s term, you could miss out on higher interest rates.
Finally, your money is locked in the CD for the term unless you pay a fee, giving you less liquidity than other accounts like a high-yield savings account.
Types of Certificates of Deposits
Here is an overview of the types of CDs you can consider.
- Standard CDs: Have terms from one month to 10 years with fixed interest rates, principal amount and terms.
- Bump-Up CDs: With a bump-up CD, the bank gives you the option to increase your APY during the CD’s maturity term. Usually, you can increase interest once during the CD’s term.
- Add-On CDs: With an add-on CD, you can make additional deposits to your initial invested principal and earn the same interest rates. Some CDs may stipulate the number of allowed add-ons per time period.
- No-Penalty CDs: You can withdraw your money without paying a penalty with these CDs. However, they typically have lower interest rates than other CDs.
- Jumbo CDs: Jumbo CDs are CDs with a large minimum deposit. There is no set minimum, so this varies by bank or institution, often from $25,000 to $100,000 or more.
- IRA CDs: IRA CDs must be held in an individual retirement account. These CDs are offered by banks and credit unions specifically for retirement accounts. Find the best IRA CD rates here.
Factors to Consider When Opening a CD Account
When opening a CD account, consider the interest rate, term length, fees and minimum deposit. You’ll want to consider your cash liquidity needs and other retirement and savings goals, including your retirement timeline, and to ensure you aren’t reducing liquidity too much or locking in low interest rates long-term.
If you shop around, you may be able to get comparable interest rates on short-term CDs and then consider re-investing the funds or using other savings vehicles. For example, if you have a high-yield savings account with a 4.5% interest rate, you’ll want to look for CDs with higher interest rates to make it worth losing liquidity.
What Happens to a CD When It Reaches Maturity?
When a CD reaches maturity, the bank will pay the interest due according to the account agreement, usually into the CD account. At maturity, you have the choice to renew the CD or withdraw the funds. The grace period for this decision varies by bank policy.
Taxation on CD Investments
You will need to report all income from CDs on Form 1099-INT. This form is used for interest income. You will receive Form 1099-INT from your bank in the year interest is paid.
Are CDs Worth It?
While other investment options can earn higher returns, they come with higher risk. CDs as part of a balanced investment portfolio can be a smart investment option. They offer low risk with the possibility of higher interest rates than savings accounts or money market accounts. Ready to get started? Find the best six-month, one-year or five-year CD rates.
Frequently Asked Questions
A
CDs are a low-risk investment that can be a good option in addition to a diversified, risk-balanced investment portfolio. CDs offer flexibility in term duration, and you can shop around for the best interest rates.
A
How much money you should put in a CD depends on your total savings, liquidity needs and timeline to retirement. Generally, you should put money in a CD to balance more high-risk investments, as long as you won’t need those funds before the CD term ends.
A
You can keep money in a CD as long as you want. You can set up a CD ladder with varying terms and interest rates. For example, the CD term could range from one month to five years.
A
CDs offered by banks are FDIC insured up to $250,000. CDs offered by credit unions are NCUA insured up to $250,000. You can check with your financial institution to confirm whether their CD products are federally insured.
A
You can cash out your CD early, but you will generally have to pay a fee. The early withdrawal fees vary by financial institution.
