Certificate of Deposit (CD)

A Certificate of Deposit (CD) is a financial product commonly offered by banks and credit unions. It is a type of savings account that has a fixed interest rate and fixed date of withdrawal, known as the maturity date. A CD is protected by insurance, either through the Federal Deposit Insurance Corporation (FDIC) for banks or the National Credit Union Administration (NCUA) for credit unions, up to the maximum allowed by law.

Key Characteristics of a Certificate of Deposit

Fixed Term

A CD comes with a predetermined term, which can range from a few weeks to several years. Common maturity periods include three months, six months, one year, and five years. The term influences the interest rate and the earning potential.

Fixed Interest Rate

The interest rate on a CD is typically higher than that on regular savings accounts, but it remains fixed for the duration of the term. Interest can be compounded at different intervals, such as daily, monthly, or annually, depending on the institution offering the CD.

Maturity Date

The maturity date is the date when the CD term ends. At this point, the account holder can withdraw the initial investment plus the accrued interest. Early withdrawals often incur penalties, which can vary based on the bank’s policy.

Principal Protection

The principal amount invested in a CD is generally protected, meaning that account holders are guaranteed to get back their initial investment, along with interest, provided they do not withdraw funds early.

Insurance

CDs offered by banks are usually insured by the FDIC up to $250,000 per depositor, per insured bank, for each account ownership category. CDs offered by credit unions are insured by the NCUA with the same coverage limits.

Types of Certificates of Deposit

Traditional CD

The traditional CD offers a fixed interest rate, fixed term, and a penalty for early withdrawal.

Bump-Up CD

A bump-up CD allows for a one-time increase in the interest rate during its term if the bank’s rates on comparable CDs rise. This feature can be beneficial if you expect interest rates to increase during the term of your CD.

Step-Up CD

Step-up CDs start with a lower interest rate that increases at specific intervals during the CD’s term. The increase schedule and final interest rate are determined at the outset.

Liquid CD

A liquid CD, sometimes called a no-penalty CD, allows you to withdraw part or all of your deposit before the maturity date without incurring a penalty. However, these CDs typically offer lower interest rates than traditional CDs.

Callable CD

Callable CDs can be “called in” or redeemed by the issuing bank before the maturity date. The bank would typically do this if interest rates fall, allowing them to reissue CDs at a lower rate. Callable CDs often offer higher interest rates as a trade-off for this risk.

Zero-Coupon CD

Zero-coupon CDs are purchased at a discount to their face value and don’t pay interest periodically. Instead, the interest compounds and is paid out in a lump sum at maturity.

Jumbo CD

Jumbo CDs require a higher minimum deposit, typically $100,000 or more, and offer higher interest rates than standard CDs. Because of the large deposit required, these are usually favored by wealthy individuals and institutions.

Advantages of Certificates of Deposit

Low Risk

CDs are considered one of the safest investments since they offer fixed returns and are insured by the FDIC or NCUA.

Higher Interest Rates

Compared to regular savings accounts, CDs generally offer higher interest rates, making them more attractive for those looking to maximize their savings without taking on significant risk.

Predictable Returns

The fixed interest rate and term provide a predictable return, making financial planning easier, especially for retirees or those saving for a specific goal.

Disadvantages of Certificates of Deposit

Early Withdrawal Penalties

Withdrawing funds before the maturity date incurs penalties, which can eat into or even exceed the interest earned, depending on terms and conditions.

Inflation Risk

The fixed interest rate may not keep pace with inflation, potentially reducing the purchasing power of the money invested over time.

Opportunity Cost

Funds locked into a CD are not liquid, meaning that they cannot be easily accessed or invested elsewhere without incurring penalties. This can be a disadvantage if more lucrative investment opportunities arise.

How to Choose a Certificate of Deposit

Shop Around

Interest rates on CDs can vary significantly between banks and credit unions, so it’s advisable to shop around and compare rates, terms, and any additional features.

Consider the Term

Select a term that aligns with your financial goals and needs. Shorter terms offer more flexibility but generally lower interest rates, while longer terms offer higher rates but tie up your money for a longer period.

Check the Penalties

Understand the penalties for early withdrawal before committing to a CD. Some institutions have more lenient policies than others.

If you expect interest rates to rise, you might prefer a bump-up CD or a short-term CD that will allow you to reinvest at higher rates sooner.

Laddering Strategy

CD laddering involves opening multiple CDs with different maturity dates. This strategy allows you to take advantage of higher rates on longer-term CDs while still maintaining access to some of your funds in the short term.

Example of a CD Ladder Strategy:

  1. Invest equal amounts in 1-year, 2-year, 3-year, 4-year, and 5-year CDs.
  2. As each CD matures, reinvest it into a new 5-year CD.
  3. After five years, you will have a CD maturing every year, providing regular access to your money while earning higher rates on the long-term CDs.

Where to Buy Certificates of Deposit

Banks

Traditional banks are one of the most common places to buy CDs. They offer a variety of terms and types and typically require you to have a savings or checking account with them.

Credit Unions

Credit unions also offer a wide range of CDs. Membership is usually required, but they often provide competitive rates and better customer service.

Online Banks

Online banks tend to offer higher interest rates on CDs because they have lower operating costs compared to brick-and-mortar institutions. Examples include Ally Bank (https://www.ally.com) and Marcus by Goldman Sachs (https://www.marcus.com).

Brokerages

Some brokerage firms offer brokered CDs, which can come from different banks and offer a variety of terms and interest rates. These CDs might be callable and can involve a higher level of complexity. Examples include Charles Schwab (https://www.schwab.com) and Fidelity (https://www.fidelity.com).

Final Thoughts

Certificates of Deposit can be an effective tool for those looking to save money with minimal risk. They offer higher interest rates than traditional savings accounts and come with the safety of FDIC or NCUA insurance. However, the trade-offs include limited liquidity and potential penalties for early withdrawal. By carefully selecting the term and type of CD that aligns with your financial goals, and possibly utilizing a strategy like CD laddering, you can maximize the benefits while minimizing the drawbacks of this financial product.