What Is a Certificate of Deposit (CD)?

What is a Certificate of Deposit ? (photo: www.wikihow.com)

A Certificate of Deposit (CD) is a type of savings product that allows you to earn interest on a lump sum of money for a fixed duration. Unlike savings accounts, CDs require that you keep your money untouched for the entire term, or else you may incur penalty fees or lose out on interest. CDs typically offer higher interest rates than savings accounts as a reward for sacrificing immediate access to your funds.

Most financial institutions catering to consumers provide CD options, but each bank determines the terms it will offer, such as the interest rate compared to its savings and money market products, and the penalties that apply if you withdraw funds before the term is up.

It's essential to shop around when looking for the best CD rates since various financial institutions provide a surprisingly broad range. For instance, your traditional bank may offer very low rates even for long-term CDs, while an online bank or local credit union might offer rates that are three to five times the national average. Additionally, some of the best rates are available through special promotions that may have unusual durations, such as 13 or 21 months, rather than the more common terms based on three, six, or 18 months or full-year increments.

Understanding Certificates of Deposit (CDs)

To comprehend Certificates of Deposit (CDs), the process of opening a CD account is very similar to opening a standard bank deposit account. The distinction is in the agreement you make when you sign the contract, even if it is now a digital signature. Once you have surveyed your options and determined which CD(s) to open, the completion of the process will commit you to four things.

- The interest rate: Locked rates are advantageous because they offer a definite and foreseeable return on your deposit during a specific period. The bank cannot alter the rate later, and as a result, your earnings will not be reduced. However, a fixed return may not be beneficial if rates rise significantly later, and you miss the chance to take advantage of higher-paying CDs.

- The term: It refers to the duration for which you commit to keeping your funds deposited to avoid any penalties, such as a six-month CD, one-year CD, 18-month CD, etc. The term concludes on the maturity date, which is when your CD has fully matured, and you can withdraw your funds without any penalties.

- The principal: Unless it's a specialty CD, this is the amount you deposit when opening the CD.

- The institution: The bank or credit union where you open your CD will determine certain aspects of the agreement, such as early withdrawal penalties (EWPs) and whether your CD will be automatically reinvested if you don't provide any other instructions at the time of maturity.

After you have established and funded your CD, the bank or credit union will manage it like most other deposit accounts, with monthly or quarterly statement periods, paper or electronic statements, and typically monthly or quarterly interest payments deposited into your CD balance, where the interest will accumulate.

Read More: IRS Tax Refund Schedule ( 2023 )

Why would I open a CD? 

CDs offer fixed, secure, and often federally insured interest rates that are usually higher than the rates paid by many bank accounts, unlike most other investments. Additionally, CD rates tend to be higher if you're willing to leave your money deposited for more extended periods.

For savers who want to earn more than what most savings, checking, or money market accounts can provide without the risks or volatility of the market, CDs have become a more attractive option.

CDs vs. a Savings or Money Market Account

CDs are a particular type of savings instrument that, like a savings or money market account, offer a way to save money for a specific goal, such as a down payment on a house, a new vehicle, or a big trip, or to hold funds that you don't need for everyday expenses while earning a certain return on your balance.

However, while savings and money market accounts allow you to adjust your balance by making additional deposits and up to six withdrawals per month, CDs require a single initial deposit that remains in the account until its maturity date, whether that's six months or five years later. In exchange for sacrificing access to your funds, CDs usually offer higher interest rates than savings or money market accounts.

How Are CD Rates Determined?

What is a Certificate of Deposit ? (photo: www.wikihow.com)

Anyone who follows interest rates or business news, in general, knows that the Federal Reserve Board's rate-setting decisions have a significant impact on the earnings savers can expect from their deposits. This is because the Federal Reserve's decisions can have a direct impact on a bank's expenses. Here's how it works:

The Federal Open Market Committee (FOMC) of the Federal Reserve decides every six to eight weeks whether to increase, decrease, or maintain the federal funds rate. This rate represents the interest that banks pay to borrow money from the Federal Reserve. When borrowing from the Federal Reserve is inexpensive (i.e., the federal funds rate is low), banks have less motivation to seek deposits from customers. However, when the federal funds rate is moderate or high, banks can offer customers a more competitive interest rate on their deposits.

In December 2008, the Federal Reserve lowered its rate to nearly zero as a way to stimulate the U.S. economy and pull it out of the Great Recession. Unfortunately for savers, the Fed kept rates at this historic low level for seven years, causing deposit rates of all types, including savings, money market, and CDs, to plummet.

Starting from December 2015, the Federal Reserve gradually increased the federal funds rate as a result of positive economic indicators that showed growth and strength in the US economy. This led to a rise in interest rates that banks paid on deposits, making top CD rates an appealing option for certain cash investments. However, in the latter half of 2019, the federal funds rate began to decline, and in March 2020, it was lowered to between 0% and 0.25% as an emergency measure to mitigate the economic impact of the 2020 crisis. As a result, these lower rates make CDs a less attractive option for cash investors currently.

When considering opening a CD and choosing a term, it's important to pay attention to the Federal Reserve's rate-setting movements and plans. Opening a long-term CD right before a Fed rate hike can hurt your future earnings, while expectations of decreasing rates can signal a good time to lock in a long-term rate.

In addition to the Fed's actions, the situation of each financial institution is also a factor in how much interest it is willing to pay on specific CDs. For example, if a bank's lending business is thriving and it needs more deposits to fund those loans, the bank may be more aggressive in attracting deposit customers. Conversely, a large bank with ample deposit reserves may be less interested in growing its CD portfolio and therefore offer lower certificate rates.

Are CDs Safe?

CDs are considered one of the safest options for saving or investing for two main reasons:

Firstly, their interest rate is fixed and guaranteed, which means there is no risk of it being reduced or fluctuating. The return you agreed to when you opened the CD is the return you will receive, as specified in your deposit agreement with the bank or credit union.

The second reason why CDs are considered as one of the safest savings or investment instruments is that they are protected by federal insurance, which also covers other deposit products. The Federal Deposit Insurance Corp. (FDIC) provides insurance for banks, while the National Credit Union Administration (NCUA) provides insurance for credit unions. This means that if you open a CD with an FDIC- or NCUA-insured institution, your funds on deposit with that institution, up to $250,000, are protected by the U.S. government in the event of the institution's failure. Although bank failures are rare these days, it is still reassuring to know that a bank failure would not put your funds at risk.

To ensure the safety of your funds, it's essential to select an institution that has FDIC or NCUA insurance, as the vast majority of them do. However, a small minority carry private insurance instead, so it's necessary to check. Additionally, to prevent exceeding the $250,000 deposit limit, it's best to avoid depositing more than that amount in your name at any one institution. If you hold more than that amount, you can maximize your coverage by dividing your funds across multiple institutions and/or more than one name, such as your spouse's.

When Is Opening a CD a Good Idea?

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CDs can be useful in various situations. For instance, if you have cash that you won't need immediately, but you'll require it in the next few years for purposes like a special vacation or buying a new home, car, or boat, then CDs can be a good investment option. The stock market isn't typically suitable for such short-term uses as you may lose money over that time.

Alternatively, you may prefer to invest some of your savings in a highly conservative manner, or you might avoid the risk and unpredictability of the stock and bond markets altogether. Although CDs may not offer the potential for growth that equity or debt investments do, they also don't carry the risk of downturns. Therefore, if you want to ensure that your money grows in value, even if it's modest, CDs can be a suitable choice.

While one of the downsides of CDs is their inflexibility, this characteristic can actually be a useful feature for certain savers. Individuals who are concerned about their ability to resist the urge to use their savings may find the fixed term of a CD and the associated penalty for early withdrawal to be a deterrent to spending. This is not the case with regular savings or money market accounts.

Using CDs for your emergency fund is one example of how this feature can be beneficial. By doing so, you can ensure that you always have sufficient reserves available in case of an emergency, as the amount in the CD will never decrease. Although you may incur a penalty if you need to withdraw funds early, the idea is that you would only do so in a true emergency, rather than for lesser, more tempting reasons. Additionally, while the funds are invested, you'll earn a better return than if you had deposited them in a savings or money market account.

Pros :

• Offers a higher rate than you can earn with a savings or money market account

• Pays a guaranteed, predictable rate of return, avoiding the volatility and losses that are possible with stocks and bonds

• Is federally insured if opened with an FDIC bank or NCUA credit union

• Can help fend off spending temptations since withdrawing the funds early triggers a penalty

Cons : 

• Cannot be liquidated before maturity without incurring an early withdrawal penalty

• Typically earns less than stocks and bonds can over time

• Earns a fixed rate of return regardless of whether interest rates rise during the term

Read More: What is Commercial Banking

Where can I find a CD? 

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Almost every bank and credit union provides at least one CD option, and many have a variety of terms to choose from. This means that not only can you find CDs at your local physical bank, but also at every bank or credit union in your area, as well as banks that offer services online to customers nationwide.

Furthermore, you can also open a CD through your brokerage account. These certificates are also issued by banks, with your brokerage firm acting as an intermediary.

Why Shopping Around is Crucial 

In the past, your options for CDs were primarily limited to what was available in your local area. However, with the advent of online rate comparison tools and the rise of online banks - as well as traditional banks offering online options - the number of CD options available has grown tremendously. It is now possible to explore CD options at over 150 banks across the country, which allow for online or mail-in account opening. Additionally, you can access regional and state banks, as well as credit unions, that will do business with you based on your state of residence.

Please note that the interest rates for CDs can vary greatly across different institutions. It's not advisable to simply open a CD at the same bank where you have a checking account without researching how its rates compare with those offered by other banks. It's recommended that you explore the available options within your state or community and utilize various online tools to filter and refine your search.

The CDs that offer the highest interest rates in the country usually pay three to five times the national average rate. Therefore, conducting thorough research on the best options available is crucial in determining how much you can earn.

How Much Do I Need to Open a CD?

To open a CD account, each bank or credit union has a minimum deposit requirement that must be met. Some banks may have a universal minimum deposit policy for all CD terms they offer, while others may have rate tiers, offering a higher annual percentage yield (APY) for those who make higher minimum deposits.

In theory, having a larger amount of money to deposit will result in a higher return. However, this is not always the case in practice. While having $25,000 to deposit may allow you to access certain CD options not available to those with lower amounts, many of the top 10 rates for each CD term can be achieved with modest investments of $500 or $1,000. Additionally, the vast majority of top rates are available to anyone with at least $10,000, and a $25,000 deposit is only occasionally required for a top rate.

Which CD Term Should I Choose?

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When choosing a CD term, there are two important factors to consider.

The first factor is your intended use for the money. If the funds are earmarked for a specific goal or project, the expected start date of that endeavor will help determine the maximum length of CD term that is appropriate. On the other hand, if you are simply saving money without a specific purpose in mind, you may want to opt for a longer term to maximize your interest rate.

The second factor to consider is the expected changes to the Federal Reserve's rate. If it is anticipated that the Fed will raise rates, resulting in higher CD rates at banks and credit unions, then short- and mid-term CDs would be a better choice than long-term CDs. This is because you wouldn't want to be locked into a lower rate for five years when new, higher rates become available. Conversely, if rates are expected to decrease in the near future, you may want to consider long-term CDs to secure today's higher rates for years to come.

What Is a CD Ladder, and Why Should I Build One?

Savvy CD investors have a strategy to minimize the risk of rate changes and maximize their returns over time. This strategy is known as a CD ladder, which allows you to take advantage of the higher interest rates typically associated with longer-term CDs, such as five-year terms, while still having access to a portion of your funds annually rather than waiting for the full five-year term to mature. Here's how to build one.

To begin with, you start by determining the total amount of money you wish to invest in CDs. You then divide this amount by five. Next, you allocate one-fifth of the funds to invest in a one-year CD with a top interest rate, another fifth to a top two-year CD, another fifth to a three-year CD, and so on until the final fifth is invested in a five-year CD. For example, if you have $25,000 available to invest, you would divide that amount by five to get $5,000. This means you could invest in five CDs of varying lengths, each with a value of $5,000.

After a year, when the first CD reaches maturity, you take the money earned and invest it in a top-rate five-year CD. Another year later, the second CD that you initially invested in for two years will mature, and you'll then invest that money in another five-year CD. You continue this process each year, investing the money earned from the maturing CD into another five-year CD, until you have a portfolio of five CDs that all earn five-year Annual Percentage Yields (APYs), with one CD maturing every 12 months. This way, you can access some of your money every year, rather than having all of it locked up for five years.

Some CD investors prefer a shorter version

of the CD ladder, which involves using six-month CDs for the lower rungs and two- or three-year CDs for the top rungs. This way, funds become available twice a year instead of once annually, but the interest rates earned are for two- to three-year CDs instead of five-year CDs.

Read More: What is Investment Banking

Why You Should Be Open to Odd-Term CDs

If you're saving money to reach a specific goal with a set timeline or creating a CD ladder, it's important to keep an open mind and consider the best CD deals you find, rather than being fixated on a particular term. This is because some banks and credit unions may offer promotional CDs with unconventional terms to attract new customers.

For example, some of the best CD rates you may come across might have uncommon terms such as five months, 17 months, or 21 months. This could be to make the offer stand out, to coincide with the bank's anniversary, or for any other reason. However, if you're willing to be flexible and consider these unique-term CDs instead of sticking to your original plan of a conventional term, you may discover a more lucrative opportunity.

How Are CD Earnings Taxed?

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When you invest in a CD, the bank will pay you interest at regular intervals, typically monthly or quarterly. This earned interest will appear on your account statements and accrue, much like the interest earned on savings or money market accounts. At the end of the year, the bank will report the interest earned to you, and you must report it as income on your tax return.

Some people mistakenly believe that they will only be taxed on their CD earnings when they withdraw the funds, either at maturity or if they cash out early. However, this is not the case. For tax purposes, your CD earnings are taxable when the bank applies them to your account, regardless of when you choose to withdraw your CD funds.

What Happens to My CD at Maturity?

As your CD approaches its maturity date, which is usually within the month or two prior, your bank or credit union will contact you to inform you of the upcoming end date. Along with this notification, they will provide you with instructions on how to inform them of what you wish to do with the maturing funds. Typically, you will be presented with three options.

When your CD reaches maturity, you will typically have three options provided by the bank or credit union. The first option is to roll over the CD into a new one at the same bank. This new CD will typically have a term that most closely matches the maturing CD. For instance, if you have a 15-month CD concluding, the bank may roll your balance into a new one-year CD.

The second option is to transfer the funds into another account at the same bank. You may choose to transfer the funds to a savings, checking, or money market account.

Lastly, you can choose to withdraw the proceeds from your maturing CD. The funds can be transferred to an external bank account, or a paper check can be mailed to you.

Regardless of the situation, the message sent to you will specify a deadline by which you need to provide instructions, along with information about what the institution will do if they don't receive your guidance. In many cases, the default option will be to transfer your funds into a new CD.

If you miss the bank's deadline for providing instructions on how to handle your maturing CD, you may end up stuck with a lower interest rate for a long time, or face an unexpected and potentially significant penalty for withdrawing your funds too late.

Is It a Good Idea to Allow My CD to Roll Over?

As a general rule, it's not advisable to let your CD roll over into a similar term at the same institution. If you don't need the funds immediately and are interested in starting a new CD, rolling it over may seem like the easiest option. However, it's rarely the option that will give you the highest return.

As we've mentioned before, it's crucial to shop around if you want to earn the best rate on your CD investments. The chances are low that the bank where your CD is maturing offers the top rate among the hundreds of banks and credit unions available for choosing a CD. While it's possible to do well with a rolled-over CD, the odds are against you, and it's always better to shop around.

Even if you discover that your current bank is indeed one of the top contenders, you can confidently move into that CD with the knowledge that you've done your research and secured the best possible return.

What If I Need to Withdraw My Money from a CD Before Its Maturity Date?

Although opening a CD requires you to keep the funds on deposit without any withdrawals until the end of the term, there are still options available if your plans change. Whether you experience an emergency, a change in your financial situation, or you believe that you can use the money more effectively elsewhere, all banks and credit unions have specific terms on how to withdraw your CD early.

However, this exit option is not free. Financial institutions usually charge an early withdrawal penalty (EWP) on the proceeds before distributing your funds, based on the terms and calculations outlined in your deposit agreement when you first opened the certificate. This means that you can assess the acceptability of the EWP before agreeing to open the CD.

In most cases, the early withdrawal penalty (EWP) is calculated as a specific number of months' worth of interest. The number of months typically increases with longer CD terms and decreases with shorter ones. For example, a bank may subtract three months' worth of interest for CDs with terms of up to 12 months, six months' worth of interest for those with terms up to three years, and a full year's worth of interest for long-term CDs. These are just examples, and every bank and credit union sets its own EWP policies. Therefore, it's crucial to compare EWP policies when deciding between two similar CDs.

It is advisable to be cautious of Early Withdrawal Penalties (EWPs) that can reduce your initial investment. The typical EWP policy mentioned previously will result in earning less than the amount that could have been earned if the CD had been held until maturity. In general, only a portion of the earned interest will be affected by the EWP, and some penalties can be very severe. In some cases, a flat-percentage penalty is charged, which may outweigh the interest earned if the CD is not held for a long time. Consequently, it is best to avoid such types of EWP.

Before deciding on a CD, it is important to review the bank's EWP policy. If the policy is particularly harsh or if a different CD with a similar interest rate and a milder term is available, it is advisable to avoid the harsh penalties.

How does a certificate of deposit (CD) work?

A certificate of deposit (CD) is a widely used and uncomplicated savings option that is offered by banks and credit unions. When an individual purchases a CD, they agree to deposit a specific amount of money with the bank for a predetermined period, typically ranging from a few months to several years. In return, the bank agrees to pay the depositor a fixed interest rate and ensure that the principal amount is repaid when the term ends. For instance, if an individual invests $1,000 in a one-year CD with a 5% interest rate, they will receive $50 as interest over the course of the year in addition to the $1,000 they initially invested.

Is it possible to experience a financial loss with a CD investment?

In practical terms, it is highly unlikely to lose money when investing in a CD due to two main reasons. Firstly, banks or credit unions that offer CDs guarantee them, thus being legally bound to pay the predetermined amount of interest and principal to the investor. Secondly, CDs are typically insured by the federal government, providing further protection to investors. Even in the unlikely event of the bank or credit union filing for bankruptcy, the principal is still likely to be repaid. Therefore, CDs are generally considered one of the safest investment options available.

What are the pros and cons of investing in a CD?

Many savers appreciate the safety and predictability that CDs offer. However, CDs typically provide a relatively low rate of return, especially in recent times where the federal funds rate is at historically low levels. Additionally, if the interest rate offered is below the current inflation rate, investors may actually experience a loss on their investment when adjusted for inflation. Therefore, investors who prioritize high yields may opt for riskier investments that offer greater potential returns.

In summary

Certificates of Deposit (CDs) are a secure investment option for individuals seeking higher returns without the risks associated with stocks and bonds. While CDs may offer higher interest rates compared to savings accounts and money markets, it's important to carefully review the terms and conditions before investing. While long-term investments may provide safety, they may also mean missing out on higher interest rates if the Federal Funds Rate increases. Additionally, withdrawing funds early from a CD may result in penalties that can eat into the principal amount. Therefore, it's crucial to understand both the limitations and advantages of a CD investment before committing to it.

Read More: How to Deposit a Check Online

Source: https://www.investopedia.com