What is a Certificate of Deposit (CD)?

Certificate of Deposit

A certificate of deposit also known in the banking world as CD is essentially a financial instrument that allows you to have a savings account with a guaranteed interest rate for a specified length of time such as 5 or 10 years. In return for keeping your money in the account, you are typically offered competitive rates of annualized return. Nearly every bank or institution that deals directly with your finances in a certain capacity features CDs as a part of their product offerings.

The rate that you receive for a CD is based on a variety of factors including the typical rates on their other standard products such as checking accounts, savings accounts, money market accounts, and personal loans. Not all banks are created equal in this regard and accepting the first offer you find may lose you several tenths of a percentage point. Institutions with low to no overhead such as Neobanks, or those that strictly do business online or via mobile application generally have the highest introductory rates. 

How does a CD work?

Once you deposit money for a set amount of time, you start earning interest on those funds. The interest is usually compounded and added to the principal. Upon opening your account you will receive not only competitive rates and guaranteed interest but also discounts on other products that the institution offers. 

The longer you keep your money in the account, the more interest that you will accumulate over the term of the CD. There are also some enhanced benefits that you will receive as opposed to going with other financial instruments for your savings goals. 

  • A single upfront deposit is required
  • Funds are federally insured by the FDIC
  • Higher interest rates due to the length of the agreement
  • Complimentary offers on alternate banking services

How are CD Rates Calculated?

Certificates of deposits are considered a form of federal funds as they are insured and regulated by the federal government and agencies such as the Federal Open Market Committee, which is tasked with overseeing markets under the Federal Reserve.

As banking rates fluctuate due to world events, capital markets, or other factors, the US dollar is strengthened or weakened which in turn affects the rates that financial institutions trade funds. Since this has a direct impact on all products such as securities, investments, financial instruments, and the like, the committee intervenes on a periodic basis to either lower or raise the APY or APR of products.

CD’s vs Savings Account vs Money Market Account

All instruments such as CDs, money markets, and high yield savings accounts allow your money to grow as it sits in your account earning interest. However, with standard accounts, the amount of deposits made heavily determines your account balances, which can dwindle as emergency situations arise. 

With certificates of deposit, your savings is according to your initial investment, which is a lump sum that must remain over a specified amount of months or years in order to gain its full value. As CDs provide above-average rates of return on interest, the funds will hold long-term value at their date of maturity.

CDs Certificates of DepositSavings AccountsMoney Market Accounts
Highest interest ratesVariable interest ratesVariable interest rates
One standard depositMultiple deposits neededRegular deposits needed
Specified withdrawal periodLimited to six withdrawalsLimited withdrawals
Unlimited rolloversBasic account optionsHybrid account options

Is Money in a CD Safe?

Due to federal regulations, any financial instruments such as a certificate of deposit are kept safe by a government-backed guarantee, through an agency called the Federal Deposit Insurance Corporation. This ensures that your funds are covered up to $250,000 per institution in the event of a loss on the bank’s part.

In addition to the deposit insurance, the funds placed into your CD will not lose their value based on fluctuation of rates or other external factors since it is locked in at the time of purchase. 

Are Certificates of Deposit a Good Investment?

Investing in a certificate of deposit is an excellent way to accumulate savings that can be used at a later date. Due to the way that the funds are protected, you will not lose any value on the original investment. Also, since the term of a CD is fixed, withdrawing funds from the account ahead of time are met with an early withdrawal penalty fee. 

Pros

  • Funds are federally insured against loss or bank failures
  • Stabilized rates compared to alternative investments
  • Option to roll over or convert funds at expiration

Cons

  • Locked-in rates regardless of market movement
  • Penalty for withdrawal ahead of maturation date

Different Types of CD’s

Certificates of deposit may initially come in a specified form however there are additional types that you have the opportunity to invest in. The following categories of CDs provide specialty rates, varying terms as well as other perks.

  • No Penalty Certificates of Deposit These types of investment instruments allow you to enjoy all of the benefits of a traditional CD with the exception of lower interest rates and the absence of an early withdrawal penalty.
  • Add On Certificates of Deposit – Choosing the option to add on provides the opportunity to add additional funds to the original deposit to increase the base amount that will earn overall interest.
  • Individual Retirement Account CDs IRAs are accounts that can be utilized in retirement. However, some financial institutions allow investments to be acquired through the account such as certificates of deposit. 
  • Bump Up Certificates of Deposit – The typical CD comes pre planned with a specific interest rate over the course of the investment term. With a bump up you will be presented with a chance to acquire a higher interest rate as it occurs within the locked-in contract term.
  • Jumbo Certificates of Deposit Varying financial institutions offer what is termed as a jumbo or CD with a significant deposit. The maximum allowable deposit does vary based on each bank’s stipulations. 

How Do I Obtain a CD?

Certificates of deposit are purchased by a vast array of banking and financial institutions. Many brokerages, credit unions, and online banks offer them as a part of their product offerings. The process to obtain a CD is rather simple as it requires account approval,product selection, financial agreement and initial deposit.

Upon being approved for the CD, a small set of variables will have to be agreed upon.

  • CD Length(term)– Time frame under which the monies will be held in the account
  • Interest Rate-The rate at which your account will earn annual interest during the account term
  • Deposit– The amount of funds that you will be holding in your account

Frequently Asked Questions

What is a CD Ladder?

A CD ladder is effectively a way to get the maximum benefit out of the varying interest rates and returns resulting from the CD maturation. The laddering process works by taking a specific amount of money and stacking it into individual certificates in equal amounts over incremental time frames. An example would be to split $3,000 into five six hundred dollar payments with CDs in 3 month, 6 month, 1 year, 2 year, and 5 year terms. Upon each expiration date the certificates would be rolled into their next level term.

What If I Need to Withdraw the Funds for an Emergency?

Early withdrawal is not recommended with a CD due to the fact that penalty fees will be assessed in most situations. An exception to this rule would be the no-penalty CD, which allows for early funds removal in exchange for a higher interest rate. However, once an early or emergency withdrawal is made then the penalty, based on accumulated interest, is deducted from the value at that specific time.

What Amount is Required to Open a CD?

The amount of funds required to open a certificate of deposit vary by institution and the type of CD that is selected. While some require minimum deposits of as much as $1,000, $5,000 or $10,000 dollars upfront, there are many banks and credit unions that do not require a specific funding balance to open this type of account.

Conclusion 

Certificates of deposit are a convenient investment and savings tool as they provide a host of benefits and financial incentives. Choosing the most optimal method to increase your savings involves the right institution,agreeable rates, and a long term savings commitment.

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