A certificate of deposit (CD) is a savings tool that offers a little more yield than you can typically find from a bank account, but comes with more strings attached. Have a plan in place before opening a CD, then, otherwise you might have to pay fees to access your cash.
What is a certificate of deposit (CD)?
A CD is a type of savings product that can be opened with a traditional bank, credit union or an online bank.
What makes a CD account distinct from other savings vehicles is that you hand over a lump sum upfront, in return for a fixed rate of return over a set period, such as a one-year CD that yields 4.50%.
Once the CD matures, you can either withdraw the original deposit along with the accrued interest, or roll all of the money over into a new CD and start the process anew.
How a CD works
There are three key terms that you need to know in order to understand how a CD can help you grow your savings:
- Term. This is the length of time that you agree to leave your funds deposited in the CD to avoid penalty fees and earn the full amount of potential accrued interest. Most CD terms range from three months to 10 years, though CDs with both shorter and longer terms exist.
- Principal. This is the sum that you agree to deposit when you open the CD, and can vary drastically across financial institutions. Some minimum deposits to open a CD may range from $0 to $1,000, while other CDs might require $10,000 or more to open.
- Interest rate. The interest rate determines how much money your principal deposit will earn over the course of the CD term. Interest rates for particular terms fluctuate, depending on the state of the economy. Currently, one-year CDs pay more than five-year CDs, in large part because the Federal Reserve has increased short-term rates, but investors believe that the economy will ultimately slow over the next few years.
How to open a certificate of deposit
Opening a CD is similar to opening any standard bank deposit account. You can typically open one in person at a bank branch, or online through the bank’s website. The bank will ask you to provide personal information and may require you to make an initial deposit to open the account.
While the process of opening an account may be familiar for many consumers, Jennifer Bush, a certified financial planner at Main Street Planning, recommends researching the best CD for a term that makes sense to you.
“It’s up to each bank which terms it wants to offer, the rate and penalties for early withdrawal, so shop around,” she said.
CD account vs. savings account
CDs and savings accounts are similar in that they’re both safe savings vehicles. If you open a CD or savings account at a bank or credit union, both will usually be insured by the Federal Deposit Insurance Corporation (FDIC).
However, CDs and savings accounts vary drastically when it comes to liquidity. A savings account typically allows you to make deposits and withdrawals at any time, while a CD requires you to keep your money on deposit for a set period of time.
Another key difference: interest rates. CD rates are generally higher than savings account rates, although rates may vary depending on the term of the CD and the current interest rate environment.
That’s the deal: Higher rates for less liquidity. (You can find middle ground with no-penalty CDs).
Therefore, you should only consider CDs if you don’t actually need the cash during the term you are considering.
Using your CD account as a savings account
While it’s important to do some comparison shopping when it comes to deciding between a CD and a savings account, now is a good time to consider CDs.
“CDs are a great option now because they’re paying interest that’s meaningful,” said John Belluardo, owner of Stewardship Financial Planning. “You can go to your local banks and get 3% to 3.5% or more, which is unheard of in the past 15 years.”
Although the interest rates on CDs are at recent highs, you still need to consider your personal financial goals when choosing between the two options. If you won’t need your savings before the maturity term of the CD, that is likely the best choice for you. Belluardo says that “for the average person CDs are a beautiful thing and I highly encourage it.”
However, if you think you’ll need the money before the term ends, a traditional savings account is usually better for your situation because you can withdraw money when needed.
Pros of using a CD for savings
A certificate of deposit offers many advantages to the average consumer, but the most important benefits are as follows:
- Low risk. CDs are FDIC insured up to $250,000 per depositor per institution, so they’re virtually a risk-free investment.
- Higher interest rates. Compared to traditional savings accounts, CDs usually offer a higher interest rate, allowing you to earn more money on your deposit.
- Predictable returns. When you open a CD, you know exactly what your interest rate will be for the term and you can plan accordingly.
- Make savings a habit. Because a CD requires you to commit to keeping your money on deposit for a set period of time, it can help you develop a savings habit.
Cons of using a CD for savings
There are also a few drawbacks to consider before you decide to open one:
- Penalties. This is the main disadvantage when it comes to CDs. If you need to withdraw the funds before the CD matures, you have to pay an early withdrawal penalty. The size of the penalty can vary depending on your bank, the CD term and the yield.
- Limited liquidity. Because you’ve agreed to leave your money locked in for a specific term, access to your money is significantly more limited compared to a savings account.
- Inflation. CD rates can’t keep up with inflation and you can lose purchasing power over time.
Frequently asked questions (FAQs)
The short answer is yes. As long as the bank or financial institution offering them is FDIC insured, your principal deposit is protected up to $250,000 in the event that the bank fails.
It depends on the interest rates and the time horizon for your savings goal.
When interest rates are low, other types of accounts, such as the stock market or real estate may be more advantageous. When interest rates are high, CDs can offer attractive returns.
When it comes to your time horizon, if you’re saving for a house or college tuition and you need the money in five years or less, a CD is a safe way to grow your money without risk to your principal. However, with a time horizon of five years or more, you’ll likely earn more with equity funds as opposed to CDs.
