Author: Marc Klein
November 01, 2021
Topics:
InvestmentsA 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.
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.
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.
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.
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:
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.
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 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.)
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.
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.
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.
Once your certificate of deposit matures and its term is complete, you typically have three options:
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:
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.
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:
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.
About the author:
Marc KleinWith 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.