As your savings grow and your all-important emergency fund nears the level that would cover 3 to 6 months of living expenses in a crisis, you’ll find you can afford to let the bank lock up some of your savings for a period of time, in exchange for a higher return.
The way to do this is through a CD, or certificate of deposit.
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CDs at a glance
A CD is an excellent way to save money and earn a higher interest rate than you would with a savings or money market account. The drawback is that CDs are not liquid; you’re tying up your funds for a period of time, and if you cash out early you’ll lose interest and possibly principal.
CDs are time-based, fixed-income investments that are most often issued by banks but can be purchased through brokerages. Some banks might require you to come into a branch to open a CD account, while others may let you open one online.
Typically, you invest a fixed amount of money for a predetermined amount of time, called the term. In exchange, you’re guaranteed a fixed amount of interest, which is added to your account periodically throughout the term. If you have a longer-term CD, you may decide to withdraw the interest payments as they are received.
When the term expires, you can cash out, or roll over the CD for another term.
Certificates of deposit:
- Earn higher interest rate than money market accounts.
- Offer time-based fixed income.
- Require you to keep hands off your investment until the CD matures.
- Have interest and possible principal implications if you cash-out early.
- Allow interest payments to be withdrawn as they are received.
- Are FDIC-insured up to $250,000 per individual.
- Are available at brick-and-mortar banks and online.
CDs can be purchased for terms of almost any duration, though the most popular terms are in a range of between 3 months and 5 years. Almost always, the longer you allow the bank to use your money, the higher your interest rate.
Generally, it’s not a good idea to buy a CD with a term of more than 5 years. The interest rate situation could change dramatically during that time and you could find yourself stuck with a long-term, low-rate CD.
CDs are deposit accounts and are insured by the Federal Deposit Insurance Corp. (FDIC) up to $250,000 per individual.
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