by Rachel Christian, CEPF®
Senior Writer
If you’re seeking higher interest rates than your traditional bank account can provide — and you don’t need access to your cash for a while — you might want to consider a certificate of deposit (CD).
But how does a certificate of deposit work, anyway? Read on.
A certificate of deposit is a savings account that holds a fixed amount of money for a certain time, such as six months, one year or five years.
During that time, your deposit earns a fixed interest rate.
Once the CD term is up, you receive the money you originally deposited back plus the interest earned.
CDs usually earn higher interest rates than a traditional savings account or money market account because you’re required to leave funds in a CD for a fixed period or else face an early withdrawal penalty.
You can buy CDs from a bank or credit union.
Bank CDs are insured by the Federal Deposit Insurance Corp. (FDIC) up to $250,000 — just like savings accounts and money market accounts.
Bank with a credit union? Ask your branch about share certificates, which are the credit union equivalent of CDs. These are also insured for up to $250,000, but by the National Credit Union Administration (NCUA) instead of the FDIC.
So long as your CD balance doesn’t exceed $250,000, you won’t lose money if the insured bank or credit union goes bankrupt or shuts down. This makes CDs a low-risk investment option.
A CD lets you earn a fixed interest rate on deposited funds with a specified withdrawal date.
To get started, you’ll fund a CD account with a lump-sum deposit. This money is called the principal.
You’ll earn a fixed interest rate on your principal for the term of the CD.
Most CD terms last from six months to five years. In some cases, you can find CDs with terms as short as a few days or as long as a decade.
Generally, the longer the CD term, the higher the interest rate.
Some banks require a minimum deposit to open a CD. These minimums can range from $500 to $10,000 or more, depending on the financial institution. However, several banks offer CDs with no minimum deposit requirements.
You’re expected to leave the money untouched until the CD matures at the end of the term. Withdrawing CD funds before the maturity date will cost you.
Specific early withdrawal penalties vary based on the term of your CD. However, they typically range from 60 to 365 days of accrued interest earnings. This can defeat the purpose of buying CD investments.
Here is some important terminology all CD investors should know.
A CD’s rate is how much interest you’ll earn on your initial deposit. A CD rate is expressed as an annual percentage yield (APY).
CDs earn higher rates than traditional savings accounts, and may earn more than a high-yield savings account.
CD rates are typically fixed: They won’t go up or down after you open your account.
That can be great if you lock in a high rate because the bank can’t give you a lower rate down the road.
On the other hand, a fixed rate can prevent you from earning more money on your deposit if interest rates later rise.
This is how long you agree to leave your money deposited in order to avoid a penalty. Terms usually range from six months to five years, with different options in between, like 1-year and 18 months.
A CD’s maturity date is when its term ends. This is when you can withdraw your funds and interest penalty-free.
You may also choose to renew a CD after it matures.
Taking money out of your CD before the maturity date usually results in a penalty.
The federal government sets a minimum penalty on early withdrawals from CDs, but there’s no maximum penalty.
Penalties are usually equal to a set period’s interest earnings. For example, you might lose 90 days or 12 months worth of interest if you withdraw funds early.
Make sure to read your CD account agreement and understand your bank’s specific early withdrawal penalty policy.
There are several pros to opening certificates of deposit.
Opening a CD makes sense when you are free of credit card debt and already have an emergency fund built up in your savings.
Because you’ll pay a fee if you withdraw money early from a CD, aim to save three to six months of expenses in a cash account before opening a CD.
Because the interest rate of credit card debt is higher than what you’d earn through a CD, it makes sense to pay off that debt first before opening a CD.
Debt-free and ready for an emergency with a healthy savings account? A CD might be right for you. But remember: Diversifying your money tends to yield the best results.
CDs have their downsides. Some disadvantages include:
CDs are widely available at many banks and credit unions across the country.
You can open a new CD at a brick-and-mortar bank or at an online bank.
Online banks can be a good option if you’re looking to earn more money with the highest rate possible. These digital institutions tend to offer more favorable APYs than traditional banks.
Not sure where to open your CD account? Here are a few companies we like.
Because long-term CDs offer higher interest rates, five-year CDs are attractive to savers.
But forking over your cash for five years can be difficult, especially if the minimum deposit is large or you expect interest rates to go up.
As an alternative, you can create a CD ladder by splitting your deposit into fifths and spreading it across multiple CDs: a one-year, two-year, three-year, four-year and five-year CD.
When the one-year CD matures, you can pocket the interest and invest the initial amount in a five-year CD. You can do the same when the two-year CD matures a year later. Eventually, you will have five five-year CDs with one maturing each year.
Depositing your money into multiple CDs of varying maturities makes funds more accessible on an annual basis but achieves the overall higher interest rate of a five-year CD versus a one-year CD.
Banks and credit unions usually offer standard CDs at a fixed rate and for a fixed duration — but that’s not always the case.
Here are some special types of CDs with unique terms.
Jumbo CDs carry a high minimum balance requirement (think $100,000 and up). However, you may not necessarily earn much more interest with a jumbo CD than you would with a traditional CD.
With this CD,  you can request a rate increase if interest rates rise during the CD term.
For example, if you opened a 5-year CD, and after two years the bank or credit union increases the rate offered on that product, you can opt into that higher rate for the remaining three years of your term.
This flexibility often requires a higher deposit and a lower interest rate. Most financial institutions with bump-up CDs limit you to one rate increase per term.
These CDs include predictable rate increases at specified intervals throughout the term of the CD.
Unlike a bump-up CD, the bank automatically raises your APY to the new, higher rate so you don’t need to ask the bank to let you opt into the higher rate.
These CDs — sometimes called no-penalty CDs — give you access to your funds without penalty. The trade off? Terms may include a higher deposit and lower interest rate.
Most financial institutions still impose some withdrawal restrictions. For example, you may not be able to withdraw money from a liquid CD penalty-free for at least seven days after you open the account.
Looking for a safe investment for your cash? CDs aren’t your only option.
Here are a few other ways to earn interest on your savings.
Series I bonds— also known as inflation bonds or I bonds — are an interest-bearing U.S. government savings bond. They earn an interest rate tied to the current inflation rate. When inflation goes up, the interest rate on I bonds increases. The rate is readjusted every six months.
You have to wait at least one year to cash in I bonds, and you’ll lose three months of interest payments if you cash in a bond you’ve owned for less than five years.
You can only purchase I bonds directly from the U.S. Treasury.
A high-yield savings account from an online bank may earn around 0.40%  to 0.60% APY. In rare cases, they may earn as much as 1%. High-yield savings accounts often require high initial opening deposits and high minimum balance requirements. Like all savings accounts, you’re limited to a certain number of withdrawals per month.
A money market account is like a savings account that usually comes with its own debit card and/or checkbook. You can make a limited number of withdrawals a month and money in the account generally earns a higher interest rate than a savings account.
You can open a money market account at many FDIC-insured banks.
Rachel Christian is a Certified Educator in Personal Finance and a senior writer for The Penny Hoarder. 
Ready to stop worrying about money?
Get the Penny Hoarder Daily
Privacy Policy
© 2022 The Penny Hoarder. – All rights reserved.
Privacy Policy and Terms of Service | Do Not Sell My Personal Information | Cookies Settings

source