What is a CD?
A certificate of deposit is a type of savings account offered by banks and credit unions. If you visit a brokerage firm, you’ll find that some of them also offer CDs from different financial institutions.
Funds in traditional CDs are tied up for a set period of time in exchange for paying a certain amount of interest. Usually, there’s a guaranteed rate of return. CDs generally offer a better rate of return than traditional savings accounts, although the gap isn’t as wide as it once was.
How does a CD work?
A CD works very similarly to a savings account, but with additional restrictions.
When you open a CD, you have to select a term. The term is the length of time that you’ll keep your money in the account. For example, if you open a CD with a one-year term, you’re making a promise to the bank that you’ll keep your money in the account for one year. After the CD’s term ends, the CD matures and you have the option of withdrawing your money.
If you make an early withdrawal from a traditional CD, you could get hit with a stiff penalty fee that eats up your interest, and potentially, some of your principal. The longer the term of the CD, the heftier the fee tends to be.
Opening a CD means giving up some financial flexibility and banks reward you for that by generally paying higher interest rates than savings accounts.
Because CDs offer less flexibility and access to your money, they’re ideal for saving money for a particular goal, especially when you have an idea of when you’ll need access to the money. They’re less useful for money you might need to access quickly, such as an emergency fund.
Once a CD matures, the bank will give you some time to make changes to the account. Often, the grace period is between five and ten days. During this time, you can withdraw your money from the account or make additional deposits. If you make no changes, most banks will automatically roll your balance into a new CD, meaning you’ll have to wait for that new CD to mature before you can make a withdrawal. This means it’s very important to keep track of your CDs and their maturity dates.
Why should you get a CD?
Since there’s generally a penalty for making an early withdrawal from a CD, it’s also a good place to store money you want to keep from touching for a specific amount of time. You’ll likely earn more than you would through a standard savings account, too.
However, a CD isn’t necessarily the best option for everyone or every circumstance. Minimum deposits for CDs are often higher than the ones tied to savings accounts. And what’s best for you all depends on what you’re trying to accomplish and how quickly you need the funds in your account. If you need the money for an emergency situation, for example, you’re better off keeping it in a savings account or money market account that’s much more liquid.
CD yields are also low compared with what you would earn by investing in bonds or putting your money in the stock market. To earn a higher rate of interest, you’ll have to aim for a riskier investment.
CDs vs. savings accounts
CDs and savings accounts both help you save money and earn interest, but choosing between them can be difficult. Each is useful in a different situation.
Traditional savings accounts are a good place to keep funds that you might need to access at a moment’s notice. That’s because they offer more liquidity than CDs: Savings accounts allow you to withdraw your money a certain amount of times per month without penalty. You might keep an emergency fund or money for very short-term goals in this type of account.
CDs, on the other hand, are better for funds you won’t need for a given amount of time. These time deposits generally come with a penalty for withdrawing money before the maturity date. And even though CDs may offer a higher rate than a traditional savings account, early withdrawal penalties can quickly diminish the return that you earn.
If you’re looking for liquidity and easy access to funds, consider keeping your money in a traditional savings account.
How to build a CD ladder
A CD ladder isn’t as fancy as it sounds. It simply indicates that someone has purchased multiple CDs at once that mature at different times. Laddering CDs is a strategy that can reduce risk and allow an investor to always have access to cash because they’ll regularly have CDs maturing at set intervals.
To start building your CD ladder, first decide how much you’d like to save and how often you want your CDs to mature. You can choose how long (or short) to make your CD ladder and use as much cash as you’d like.
As an example, let’s say you want to build a five-year ladder with five rungs. If you have $5,000 to invest, you could place $1,000 in each rung. It would look like this:
- $1,000 in a one-year CD.
- $1,000 in a two-year CD.
- $1,000 in a three-year CD.
- $1,000 in a four-year CD.
- $1,000 in a five-year CD.
When your one-year CD matures, each of the other CDs moves up a year in maturity. That means your two-year CD would mature in a year, your three-year CD in two years and so on.
One way to extend the ladder even further is by rolling the money from a CD that has just matured into a new five-year CD. You can continue that pattern by purchasing a new five-year CD each time a CD matures.
Use this calculator to help build a CD ladder that works best for you.
Types of CDs
There are many different types of CDs. Here’s a breakdown:
- Traditional CDs: Traditional CDs are one of the most common types of CDs. They feature a fixed interest rate and a fixed term. You will get hit with a penalty for withdrawing your money early.
- No-penalty CDs: These CDs, also known as liquid CDs, offer the ability to withdraw money without a penalty. They may have lower rates than traditional CDs with the same term.
- Jumbo CDs: These CDs require a larger deposit than traditional CDs, often of $100,000 or more, and they can pay more than traditional CDs.
- Bump-up CDs: If rates rise during the CD term, bump-up CDs give you the option of asking the bank to increase your rate. You’re usually limited to one increase per term.
- Step-up CDs: Like bump-up CDs, step-up CDs offer the ability to increase your rate in a rising-rate environment. The difference is that step-up CDs offer automatic increases at certain intervals.
- Brokered CDs: Certificates of deposit sold through a brokerage firm are brokered CDs. You need a brokerage account in order to get one.
- Zero-coupon CDs: Similar to bonds, you purchase a zero-coupon CD at a discount to its par value (or the amount you will receive when the CD matures).
- Callable CDs: While they may provide higher yields than traditional CDs, there’s a risk: Callable CDs can be called back by the bank before the CD matures.
- IRA CDs: These are CDs held in an IRA, or individual retirement account.
- Add-on CD: Unlike many other CDs, add-on CDs allow you to make several deposits during the CD term.
Pros and cons of CDs
There are several benefits to investing in CDs. There are also some downsides.
What CD term should I get?
Choosing the term of your CD is important. It determines the interest rate you’ll earn and how long you have to leave your money in the bank.
If you’re saving for a particular goal, the decision becomes easier. For example, if you know that you want to go on vacation twelve months from now, opening a twelve-month CD makes sense. If you need cash to buy a car three years from now, you can open a three-year CD with your current savings.
If you’re saving without a particular goal in mind, you should consider a couple of factors.
- One is the interest rate. Longer-term CDs tend to have higher interest rates than short-term CDs, meaning your savings will grow more quickly. At the same time, placing additional restrictions on your money might not be worth the benefit. If the interest rate difference between a one-year and five-year CD is a tenth of a percent, the five-year CD probably isn’t worth opening.
- Another thing to consider is the early withdrawal penalty. If you foresee a situation where you might need to make an early withdrawal, you’ll have to find a balance between the interest rate and the potential penalty.
It’s relatively easy to find CDs with three, six, nine, 12, 18, 24, 36, 48, and 60-month terms, but it is possible to find longer or even shorter terms. There are also banks that offer CDs with unusual terms, like 13 or 17 months.
In today’s low interest rate market, shorter-term CDs tend to be more popular because the rates offered by longer-term CDs typically aren’t significantly higher than those for short-term CDs.
For the most part, CDs are safe investments found at banks and credit unions offering a guaranteed rate of return. You have to keep your money locked up for a set period of time, but in exchange, you’ll often get a higher rate than you would with a traditional savings or money market account.
If you’re looking for a safe, interest-bearing account to keep cash for short-term goals, consider opening a certificate of deposit.