Here's What Happens When You Open Your First CD

The short answer to what happens when you open your first certificate of deposit (CD) is: "Not a lot." That's part of the point of a CD. You get paid interest for leaving your money alone for a set amount of time. How long depends on your CD term, which can be anything from a few months to several years.

There's a lot of excitement around CDs at the moment because some are paying APYs of 5% or more. Let's say you invest $1,000 in a 3-year CD that pays a 4.5% APY. The interest on a CD usually compounds, so you can earn interest on your interest. You'd earn $45 in interest in the first year and over $140 in total.

Opening your first CD

Before you open your first CD, know that it's not the same as a savings account. If you want to take money out of your CD before the term is up, in most cases you'll have to pay a penalty. That makes it an ideal vehicle for, say, the dream vacation you plan to take in two years' time. But it's not so ideal for something like your emergency fund that you may need to access in a hurry.

Here are some questions to consider:

How long do you want to tie up your money for?

CD terms typically vary from six months to five years. One way to decide which CD term is right for you is to think about when you may need to access your money. Usually, you'll find that longer terms pay higher APYs. That's not the case right now, primarily because banks aren't sure what's going to happen in the coming three to five years.

As a consumer, that mismatch can make it harder to decide between a short- and long-term CD. Bear in mind that interest rates might fall in the years to come. This could make it worth locking in at a higher rate now, even if that rate is lower than you'd get with a shorter-term CD.

What type of CD is best for you?

There are several different types of CD, including traditional CDs, jumbo CDs, and no-penalty CDs. Learn about what each one does, and look into the minimum deposits involved. Some CDs don't require any deposits, but others may have minimums of $500 or $1,000. The minimums on jumbo CDs can run to $100,000.

Which bank or credit union offers the best rates?

Shop around to find the best CD rates that match your CD term and minimum deposit. Make sure that the account you choose is FDIC insured, as this will protect you against bank or credit union failure. It's also worth thinking about how you want to receive the interest. Some CDs make regular interest payments throughout, while others pay a lump sum at the end of the term.

Getting the most out of your CD

The trick with every savings or investment vehicle is to understand what it does, and what the pros and cons are. This can help you know when to use it. For example, the benefits of a CD are that you get a decent fixed rate of interest for a set amount of time. The downside? Your money will be tied up and the returns may not keep up with inflation. There are times when a savings account, money market account, or investment account might make more sense.

Here are a few different ways to get the most out of your CD:

• Take action before your CD ends: Many CDs will automatically rollover into a new one if you don't do anything at the end of the term. That might mean you get a lower rate, or unintentionally tie up cash you need. Don't just forget about your CD -- set a calendar alarm so you can actively decide what to do with your money when the time comes.
• Consider CD laddering: CD laddering is essentially a strategy that gives you the high APYs of CDs without sacrificing flexibility. Let's say you have $5,000 that you want to put into a CD. Rather than putting it all into a single CD, you might stagger your investments. You could put $1,000 into a 1-year CD, $1,000 into a 2-year CD, and so forth. Each year, another CD would mature and you'd have the option to use or re-invest that money.
• Avoid early withdrawal penalties: There is such a thing as a no-penalty CD, but the rates may not be as high as a traditional one. Otherwise, if you make an early withdrawal, you'll pay a penalty. This could equal several months of interest, depending on the CD. Think carefully about when you might need that money, and consider using a high-yield savings account if you're not sure.

Bottom line

Opening your first CD can be an important step. It's a pretty safe way to earn a guaranteed rate of interest on your money. Used correctly, it can be a valuable tool in your savings and investment arsenal.