What Is a CD in Banking

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CDs have been a popular investment tool since the 1960s and have been around in some form for centuries. However, many people still have basic questions about them, such as "What does CD stand for?" "What is a bank CD?" and "How do bank CDs work?"

For those who grew up in the 1990s, CD may bring to mind compact discs, like that Spin Doctors album you bought the day it was released. However, in the context of banking, CD stands for certificate of deposit.

A certificate of deposit is an account that allows you to save money at a fixed interest rate for a fixed amount of time, such as 6 months, 1 year, or 5 years. By leaving your money in the account, banks offer an interest rate that is usually higher than what is offered by a traditional savings account.

How does a certificate of deposit function? 

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It is a way to save money beyond what you have accumulated in your savings account, without taking on much more market risk. It's similar to buying a baseball card for your favorite player, knowing that its value will increase when he retires in a year or two. However, in this case, you know precisely when he will retire and exactly how much the card will be worth when he does.

To invest in CDs, you deposit a specific amount of money, such as $5,000 or $10,000, into an account and agree to keep it there for a fixed period in exchange for a set interest rate. So, if you open a 1-year CD with a 2.25% annual percentage yield and deposit $10,000, your account would be worth $10,225 after a year, assuming you keep the interest payments in the account. Not a penny more or less.

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Is a certificate of deposit suitable for you? 

Well, it depends - just like collecting baseball cards, there are advantages and disadvantages of investing in CDs. Evaluating these pros and cons will help determine if they are suitable for you and your finances.

One significant advantage of CDs is predictability. Due to the fixed rate and specific term, you will know precisely how much money you will have at the end of your investment. Additionally, they are usually insured by the Federal Deposit Insurance Corporation (FDIC) up to allowable limits, which means that your money is secure from a bank failure at FDIC-insured institutions.

One disadvantage of certificates of deposit is their inflexibility. Unlike a savings account, you cannot withdraw your money whenever you want, at least not without incurring a penalty in many cases. If you decide to withdraw early, most banks charge you some of your accrued interest, and possibly even a portion of your original investment.

Another drawback is that CD interest rates can sometimes struggle to keep up with inflation. When inflation rises, the value of your dollar decreases. So, if you invest $1,000 in a 1-year CD with a 1.5% interest rate, and inflation rises by 1.9% in that same year, your money will be less valuable at the end of the year.

Are there ways to use CDs but stay flexible?

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If you are interested in using CDs but also want to maintain flexibility with your funds, you may want to consider creating a CD ladder. This is a strategy in which you open multiple CD accounts for varying lengths of time, such as 6 months, 1 year, 2 years, and so on. By doing this, you can enjoy the benefits of a longer savings timeline while still being able to access some of your funds along the way.

For example, let's say you have saved up enough in your savings account to cover yourself in the event of a financial emergency. You have an additional $10,000 that you want to set aside, and you do not anticipate needing the money for some time. You would like to earn a slightly higher interest rate than you do in your savings account, but you are not yet prepared to invest in the stock market. What options do you have?

You have the option to invest all $10,000 into a 5-year CD, but this would mean that you cannot access the money without incurring a penalty for 5 years. To avoid this, you could split the $10,000 into smaller amounts and purchase 5 CDs, each with a different maturity period (1-year, 2-year, 3-year, 4-year, and 5-year). By doing this, you can earn more interest each year while still having access to some of your funds annually. After a year or two, you can decide whether to spend the money or reinvest it in a new CD, either a 5-year CD or something else entirely.

Some banks may offer flexibility regarding when you receive interest payments, allowing you to choose whether to receive them monthly, annually, or at the end of the term.

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What is an IRA CD?

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An IRA CD is a retirement savings option that is similar to a bank CD but with added tax benefits. It is a good choice for individuals who are approaching retirement or those who want a secure and reliable investment option. Unlike more aggressive IRA investments such as stocks and bonds, bank IRA CDs offer fixed rates and are typically FDIC insured up to the allowed limits, which means they carry lower risk of losses.

The IRA CD functions similarly to a bank CD, with fixed terms, rates, and early withdrawal penalties. A Roth IRA CD is the same, but with the tax implications of a Roth IRA instead of a traditional IRA.

Ultimately, the decision to invest in a CD depends on your personal financial goals and circumstances. However, it's likely time to let go of those old compact discs.

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Source: https://www.capitalone.com