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Wondering whether a certificate of deposit should be part of your investment portfolio? Learn how a CD works and why purchasing one might be right for you.
Certificates of Deposit Explained

What is a Certificate of Deposit?

A certificate of deposit, more commonly referred to as a CD, is an investment product offered by banks and credit unions that typically offers a higher rate of return than a standard savings account. However, to get that return, you agree to make an initial deposit of at least a minimum amount required to open the CD and leave that money untouched for a predetermined time period, the CD’s term. Once that term has been reached, you may withdraw your deposit plus the interest it accrued.

Understanding CDs and How They Work

To better understand certificates of deposit and how they work, it’s helpful to first define some of the key terms used to describe them.

  1. Issuing Institution: This is the financial institution that sells you a certificate of deposit, holds your money, and pays the earned interest. The issuing institution is either a bank or a credit union. You may buy CDs from a brokerage firm as well, but the broker is serving as a middle-man and purchases the CD for you from a bank or credit union.  
  2. Initial Deposit or Principal: This is how much money you initially deposit to open a CD. There is typically a minimum deposit required to open a CD, which can vary widely by the CD and issuing institution.
  3. CD Term: The term of a CD is the length of time you, the investor, agree to leave your funds untouched. There are many options, typically ranging from six months up to ten years. Once you’ve reached the end of the term, known as the maturity date, you are free to withdraw your money, including accrued interest. Typically, the longer the term, the higher the interest rate. 
  4. CD Interest Rate (APY): This is the interest rate paid on the CD, expressed as an annual percentage yield, or APY. APY is used to express interest rate because interest on a CD compounds—daily, monthly, quarterly, semiannually, or annually—and how often it compounds determines what the interest rate actually is. CD interest rates may be fixed, which means they will never change for the term of the CD, or they may be variable and rise or fall based on other factors such as the U.S. Prime Rate, market indexes, or even consumer price indexes.
  5. Early Withdrawal Penalty: To discourage CD investors from withdrawing funds before the CD’s maturity date, most CDs assess a monetary early withdrawal penalty, set by the issuing institution. If the penalty is substantial enough, you could lose money on your CD investment by not letting it fully mature. 

The way a typical certificate of deposit works is, you make the initial required deposit with a bank, let’s say $5,000, and agree to leave that money untouched for the CD term, let’s say five years in this example. In exchange for having your money at their disposal, the bank agrees to pay you an APY of 3%. At the end of the five-year term, when the CD has fully matured, your $5,000 investment would be worth $5,796.37, earning you $796.37 in interest.

Why Invest in a CD?

The main reason people invest in CDs is because they are a low-risk, safe investment. While they may not offer the same rates of return as other higher-risk investments like stocks or bonds, they typically pay a higher interest rate than common savings accounts. And, unlike riskier investments like stocks, CDs are a safer investment because most certificates of deposit are federally insured up to $250,000.

If you have funds that you don’t want to put into riskier investments, but you’d like to earn a higher rate of return than offered by most savings accounts, a certificate of deposit could be a good place to put your money—so long as you can leave it untouched for the term of the CD.  

How Does a CD Issuer Determine Rates?

The financial institution issuing a CD is free to set the interest rate it offers and how often it compounds interest, which determines APY. Issuing institutions would typically consider the following factors in determining the rates they offer:

  • Federal Reserve Actions: When the federal funds rate is low, banks and credit unions have less of a need to bring in deposits from consumers, so CD rates may not be as attractive as when it costs them more to borrow money from the Fed.
  • Rates Other Issuing Institutions Are Paying: Unless they’re looking to really set themselves apart, a bank or credit union would likely set their CD interest rates in the same general range as their competitors.
  • Anticipated Returns on CD Deposits: If a bank or credit union expects to earn great returns on investments they make using CD deposits, then they may be willing to pay CD investors a higher interest rate.
  • CD Term Lengths: The longer you, a CD investor, are willing to commit your money, the higher the APY typically is. That’s because savvy investors are not typically willing to lock up their funds for a long period of time for a low rate of return.      

Are CDs Safe and Risk-Free?

Because CDs purchased from a bank or credit union are federally insured by either the FDIC or NCUA, they are covered for up to $250,000 per account owner, per insured financial institution. However, your CD investment could be more at risk if purchased from a brokerage firm.

Because a brokerage firm serves as a middleman, the CD they purchase from a bank or credit union and then sell to you is federally insured, but the firm is technically considered the purchaser, so they would get any insurance money if the issuing bank or credit union were to fail. So long as the brokerage firm is reputable and stable, you would be reimbursed. However, if the brokerage firm is disreputable or even fails itself, there’s no guarantee that you would get your funds back.

It’s also possible to lose money on a CD if you withdraw funds before your CD matures. If the early withdrawal penalty is substantial enough, it could negate any interest you’ve earned and even take a bite out of your principal.

When Is the Best Time to Invest in a CD?

Anytime can be a good time to invest in a certificate of deposit, so long as you’re earning a higher return than the rate of inflation. However, there are certain life events or investment strategies where it makes good sense to open a CD, including but not limited to:

  • You’re Creating an Emergency Fund: By investing money in a CD and leaving it for the term of the CD, you’ll have that money on hand for an emergency. Just be aware that you may have to pay an early withdrawal penalty if you withdraw money from your CD emergency fund before the maturity date.
  • You’re Saving for Something in the Future: This could be anything from a college fund for your kids to a wedding to a dream vacation. If you plan on taking that vacation in four years, then opening a four-year CD and cashing it out for your trip could be just the ticket.
  • You Want to Diversify Your Investment Portfolio: By selling off investments like stocks and bonds and investing that money in lower-risk CDs as you progress on your investment journey, you diversify your portfolio and hedge against risk.
  • You Have Cash on Hand but Aren’t Sure Where to Invest It: If you’re in the process of investigating investment opportunities, or you want to take a break from riskier investments while you see where the market is heading, parking money in a CD is a low-risk proposition. Just be sure you don’t open a longer-term CD if you want to access that money within the next year or two.   

Where Can I Purchase a CD?

You can purchase a certificate of deposit through most any bank or credit union, typically online or in person. You can also buy CDs from strictly online banks. A third option is to purchase a CD through a brokerage account, where the brokerage firm acts as a middleman.

Be aware that purchasing a CD through a brokerage firm could expose you to more liability than if you purchase it through a bank or credit union. (See Are CDs Safe and Risk-Free section above.)  

Shop Around Before Investing in a CD

Because interest rates offered on CDs can vary by the issuing institution, it makes sense to spend some time shopping for a CD that’s going to optimize your investment. But it’s not just interest rates you should be shopping for; minimum deposits and term lengths can vary greatly as well and should factor into your buying decision. For instance, even if you find a certificate of deposit that offers an attractive interest rate, if the required initial deposit is more than you have on hand to invest, that CD is not an option.

With the advent of online banking and a multitude of strictly online banks, shopping around can be as easy as searching key words like “certificate of deposit” and “competitive rate.” Many websites on the internet also do the heavy lifting for you by offering comparisons and rankings of popular CDs. 

What Is the Minimum Deposit Required to Open a CD?

There is no set minimum deposit to open a CD, and issuing financial institutions are free to set their own amounts. You may be able to find a CD for as little as $500, and there are CDs with no maximum cap. However, to keep your money safe, you wouldn’t want to invest in a CD worth more than the $250,000 limit for which it is federally insured.

Since interest is calculated based on the initial deposit, the greater the initial deposit, the more total interest you’ll earn. But making a larger deposit does not necessarily mean you’ll get a higher APY than you would with a lesser deposit.

Which Term Is Best for a CD?

There is no “best” term for a certificate of deposit, and what’s best for you depends on your needs and when you’re going to need your money. Let’s say, for example, that you open a CD to earn money for a wedding you’re planning on having in two years. Well, based on that investment strategy, you wouldn’t want to tie up your money in a CD with a term any longer than two years.

As mentioned, longer-term CDs typically pay a higher APY. But there is some risk in tying up your money for longer periods of time. For example, if you purchase a five-year CD with an APY of 2% and, after 2 years, similar CDs are paying 3%, for three years you would be earning 1% less than you could if that money was invested in a higher-yield certificate of deposit paying 3%. Of course, interest rates could go down as well, in which case locking in a more favorable interest for five years could turn out to be a shrewd move.

Determining the right term length for your CD is a balancing act that needs to factor in interest rates, when you might need access to your money, and opportunities you could miss by tying up your money for too long.   

What Should I Do When My CD Matures?

Once your certificate of deposit matures and its term is complete, you typically have three options:

  1. Take the money and run. Your deposit and accrued interest can be paid to you as a check or transferred to an external account.
  2. Let it roll! You have the option of rolling the money from the matured CD into another CD of your choice. This is a good option if your investment strategy involves creating a CD ladder (see next section).
  3. Deposit the money into an account with that same bank, credit union, or brokerage firm. Depending on the financial institution, they can deposit the money from the matured CD into a savings, checking, or money market account.

What Is a CD Ladder, and Should I Build One?

A CD ladder is an investment strategy that involves purchasing certificates of deposit with staggered maturity dates. This strategy helps you take advantage of higher APYs typically paid on longer-term CDs without tying up all your money in a long-term CD. It may sound complicated, but it’s really not. Here’s an example of how a CD ladder might work.

Let’s say you have $5,000 to invest. Rather than placing the entire $5,000 in a five-year CD with the highest APY and having all of that money unavailable for half a decade, you could split it up and invest it as follows:

  • $1,000 in a one-year CD with 2.0% APY
  • $1,000 in a two-year CD with 2.25% APY
  • $1,000 in a three-year CD with 2.5% APY
  • $1,000 in a four-year CD with 2.75% APY
  • $1,000 in a five-year CD with 3.0% APY

After a year, when the one-year CD matures, invest those funds in a new five-year CD. After two years, when the two-year CD matures, cash it out and buy another five-year CD. Then, after three years, do the same with the three-year CD, then the same with the four- and five-year CD on Year Four and Five respectively.

At the end of five years, you will have only higher-yield, five-year certificates of deposits, and each subsequent year, one of those CDs will mature.  

Here’s the beauty of the ladder you’ve built—you eased your way into the CD ladder, which gave you access to some of your money every year. But, after five years, your ladder is made up entirely of higher-yield, longer-term CDs and you still have access to some of your money every year.

Are There Different Types of CDs?

A “typical” certificate of deposit is offered by a bank or credit union with a fixed term, a fixed interest rate, and an early withdrawal penalty. However, there are other types of CDs that are less typical, including but not limited to:

  • Variable-Rate CD: With this type of certificate of deposit, the interest rate is not fixed and can fluctuate throughout the life of the CD. If interest rates rise, this can be advantageous; if they drop, it can be disadvantageous.
  • Brokered CD: This type of CD is offered by a third-party, such as a brokerage firm or sales rep that isn’t a bank or credit union. Brokered CDs typically pay a higher interest rate than one purchased directly from a bank or credit union because the market is typically more competitive. It’s important to note that, unlike CDs purchased from a bank or credit union, not all brokered CDs are federally insured. 
  • Jumbo CD: This is like a typical CD only it requires an atypically high minimum deposit, usually ranging from $50,000 to $100,000. 
  • High-Yield CD: A certificate of deposit that offers better than average rates. Higher yields are typically offered by online banks and credit unions that have lower overhead than banks and credit unions with physical branches.
  • No-Penalty CD: As the name suggests, there’s no monetary penalty for a withdrawal before the CD’s maturity date. Since they are lower risk to consumers, they generally pay lower interest rates than CDs with early withdrawal penalties.
  • Bump- and Step-Up CDs: With these types of CDs, if interest rates increase, you can get a rate increase one or two times during the term of the CD, depending on the length of the term. With a bump-up CD, you must request the increase; with a step-up CD, increases happen automatically at scheduled intervals.
  • Add-On CD: This type of certificate of deposit allows you to add to your initial deposit over the term of the CD.
  • IRA CD: This type of CD must be held in an official individual retirement account and offers tax advantages.

How Does a CD Differ from a Savings Account or Money Market Account?

CDs, savings accounts, and money market accounts are all federally insured accounts. The primary difference between a CD and savings account or money market account comes down to the ability to access your money. With either of the latter, you can withdraw money or make deposits to alter the account balance.

But, with a CD, unless it’s a no-penalty CD, you’re not allowed to touch your funds until the maturity date. If you do, you could be subject to a substantial monetary penalty. CDs typically pay higher interest rates than savings accounts or money markets to reward you for leaving your funds untouched.

Another difference is that savings accounts typically require much lower initial deposit amounts than CDs or money market accounts—unless it’s a high-yield savings account. High-yield savings accounts and money markets typically have minimum-balance requirements that must be maintained after they are opened, which is not a concern with a CD because you’re typically not allowed to touch the money after you deposit it without incurring a penalty.    

So, What Are the Pros and Cons of a Certificate of Deposit?

Advantages of CDs

  • They’re federally insured and relatively low risk
  • They offer higher returns than other similar options, like savings accounts
  • They pay a predictable, guaranteed rate of return
  • They’re easy to purchase and maintain
  • They’re a good vehicle for raising funds designated for a specific purpose
  • They’re a good place to keep funds you’re not yet ready to invest elsewhere
  • They can be laddered as an investment strategy

Disadvantages of CDs

  • Their returns may not be as high as other investments such as stocks or bonds
  • Your money is tied up and inaccessible for the term of the CD
  • There is typically a monetary penalty for early withdrawal
  • Interest rates are typically fixed, so if interest rates rise, you may be locked in at a lower rate
  • They require a minimum deposit amount, which may be more than you have on hand to invest

About the author:

Marc Klein

With his eyes set on becoming the next great ad man (at least until his comedy writing career took off), Marc earned his journalism degree and went straight into advertising for various gaming and tourism clients. He later expanded his credentials to include public affairs and communications work for several environmental science organizations before returning to his marketing roots. A lifelong scholar with recent studies in strategic communication, Marc enjoys tying humor into his writing and simplifying complex financial subjects into engaging and easy-to-digest content for a wide variety of audiences.

This material is for informational purposes only and is not intended to replace the advice of a qualified tax advisor, attorney or financial advisor. Readers should consult with their own tax advisor, attorney or financial advisor with regard to their personal situations.