If you're on a Galaxy Fold, consider unfolding your phone or viewing it in full screen to best optimize your experience.
A certificate of deposit, also known as a CD, is a type of bank account that involves placing a deposit with a financial institution for a certain amount of time, and generally pays higher interest than a basic savings account. But how does a CD work?
While a CD is technically a type of savings account, it differs from a traditional bank savings account in a few important ways -- some include:
The interest rate paid by a CD depends on a few factors. For one, overall financial market conditions tend to influence CD yields. Specifically, if the Federal Reserve raises interest rates, CD yields will generally rise across the board. On the other hand, when the Federal Reserve lowers interest rates, CD yields tend to fall.
Having said that, the type of financial institution offering the CD also plays a big role. Brick-and-mortar banks tend to have lower CD yields than credit unions, for example. And, online financial institutions tend to have the best CD yields of all. As an example, as of Oct. 19, 2020, the national average interest rate for a 12-month CD was just 0.18%. Meanwhile, Marcus by Goldman Sachs offers an annual percentage yield, or APY, of 0.65% -- roughly four times the average. It's very important to shop around for the best CD rates as the variation between institutions can be substantial.
Additionally, it's important to mention that CDs offer compounded interest throughout the term. For example, let's say that you deposit $1,000 in a five-year CD that has an annual percentage yield of 3%. This means that at the end of the first year, your CD would be worth $1,030. Then during the second year, you would earn 3% on $1,030. Over time, this can really add a significant amount to your returns if you choose a CD with a longer maturity.
If you have a lot of money to deposit, you may be able to obtain a so-called Jumbo CD. Many financial institutions are willing to pay a higher interest rate for Jumbo CDs, but not all of them do, so if you have a large deposit, be sure to inquire about Jumbo CD rates.
Jumbo CDs are generally defined as a minimum deposit amount of $100,000, but many institutions have lower thresholds that pay preferable interest rates.
It's also important to mention that you can hold CDs in certain retirement accounts, such as individual retirement accounts, or IRAs. If you put your money in a CD with a bank, the interest your account earns is generally considered taxable income.
However, if your CD is held in an IRA or other tax-advantaged retirement account, you won't have to worry about paying tax on the interest you receive on an annual basis. If you invest in a CD through a tax-deferred retirement account like a traditional IRA, your account deposit may be tax deductible, and you won't have to worry about any income taxes on your interest income until you make a withdrawal from the account. Or, if you invest through an after-tax account like a Roth IRA, your contributions won't be deductible, but qualified withdrawals from the account (including your interest income) will be 100% tax-free.
If we're defining risk as the potential loss of your deposit, the answer is almost certainly no. Bank CDs are FDIC-insured up to $250,000 per depositor, per institution. And credit union CDs are also insured through the National Credit Union Administration with the same limits.
In other words, if your bank goes out of business, these insurance programs guarantee the money in your account will be safe. If you have more than $250,000, you can still be fully insured by opening CDs at several different institutions.
Having said all of that, there's another type of risk to mention that is very important to understand before opening a CD -- interest rate risk.
Let's say that you open a five-year CD with an APY of 3%. If the market interest rate spikes to 6% a few months after you open the account, you're locked into the lower 3% rate for several more years. Meanwhile, if your money had been in a savings account, the interest rate you get paid generally rises and falls with the market rates over time.
One way to avoid this is by creating a CD ladder, which involves depositing your money into multiple CDs of varying maturities. For example, if you have $5,000, you might deposit $1,000 into a 12-month CD, $1,000 into a two-year CD, and so on. This way, one-fifth of your money will be available every year, which can then be invested at the then-current long-term CD rates.
To be clear, you are allowed to withdraw money from your CD whenever you want. However, if you choose to do so before the maturity date is reached, you'll typically be charged an early-withdrawal penalty.
In most cases, the early-withdrawal penalty for a CD is based on the interest rate you receive and the stated term length of your CD. Using Marcus by Goldman Sachs as an example, here's that institution's early withdrawal penalty structure:
|CD Term Length||Early Withdrawal Penalty|
|Less than 12 months||90 days' simple interest|
|12 months - 5 years||270 days' simple interest|
|Longer than 5 years||365 days' simple interest|
It's worth mentioning that many institutions also offer no-penalty CDs, which allow customers to withdraw their money at any time. These often come with significantly lower interest rates than standard CDs. For example, I mentioned that Marcus' standard APY on a 12-month CD is 0.65% as of October 2020. For a no-penalty 12-month CD, the bank offers an APY of 0.55%, which is actually lower than its standard savings account APY of 0.60%, but it will be locked in for 12 months. Furthermore, partial withdrawals are generally not allowed from no-penalty CDs.
In other words, if you want the ability to withdraw your principal at any time, you may be better off with a high-yield online savings account than a no-penalty CD, as the interest rates are generally comparable and you'll have the flexibility to only withdraw as much money as you need at any given time.
It's a smart idea to keep some of your assets in cash, and a CD can be a smart way to do that if you're reasonably certain that you won't need to access the money for the entire maturity length. Emergency savings or money you'll need to cover day-to-day expenses is usually better off in a standard savings account. Before you deposit money into a CD, it's important to shop around for the best possible yield, as there can be big differences between financial institutions.
Here are other questions we've answered:
We're firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. The Ascent does not cover all offers on the market. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team. The Motley Fool has a Disclosure Policy. The Author and/or The Motley Fool may have an interest in companies mentioned.
The Ascent is a Motley Fool service that rates and reviews essential products for your everyday money matters.
Copyright © 2018 - 2022 The Ascent. All rights reserved.