A certificate of deposit, or CD, is a type of account that can allow savers to lock in a specific interest rate for a certain time and can be a great solution if you're looking to maximize the returns from your rainy-day cash. In this article, we'll look at exactly what a CD is, whether it might be right for you, and how you might be able to use it in your financial planning.
What is a CD?
A certificate of deposit, or CD, is a type of bank account that requires the account owner to agree to keep their money in the account for a certain period. For this reason, CDs are also known as time deposits in the banking world.
For example, if you open a one-year CD, you are required to leave the money in the account for a full year. Common lengths for CDs range from about three months to six years, although it isn't unheard of to find CDs with shorter or longer terms.
How CDs earn interest
In exchange for your agreeing to keep your money in a CD for a certain period, banks are generally willing to pay higher interest rates than for savings accounts. They pay fixed interest rates that are typically expressed as annual percentage yields, or APYs, which tell you how much your CD will grow each year.
What happens if you need your money early?
You can withdraw money from a CD before it matures, but there’s usually a cost. Most CDs charge an early-withdrawal penalty, often equal to several months’ worth of interest.
No-penalty CDs
Some banks offer no-penalty CDs, which allow you to withdraw your money before maturity without paying a fee. These can be a good option if you want a higher rate than a savings account but still need flexibility.
The trade-off is that no-penalty CDs typically offer lower APYs than traditional CDs with the same term. They also often require you to keep your money in the account for a short initial period before withdrawals are allowed.
Automatic renewals
Most CDs automatically renew upon maturity. You'll usually have a grace period -- say two weeks prior to maturity -- during which you can express your intention to withdraw the money. But if the bank doesn't hear from you, there's a high probability the account will automatically renew for another term of the same length at the then-current interest rate.
Are CDs safe?
Yes. CDs offered by banks are insured by the Federal Deposit Insurance Corp. (FDIC) for up to $250,000 per depositor, per institution. That makes CDs one of the safest places to store cash.
CD ladders can be a smart strategy
Two forces often work against CD investors:
- Longer terms usually offer higher APYs.
- Longer terms also tie up your money and increase early-withdrawal penalties.
One potential solution to this dilemma is to create what's known as a CD ladder.
How a CD ladder works
A CD ladder involves splitting your money into several equal parts and using it to buy CDs with various maturities. For example, if you have $10,000, you might open five different CDs with maturities of one, two, three, four, and five years.
The idea is that some of your money will always be within one year of maturity and some will be locked in at longer-term interest rates. If you need the money as it matures, you can use it. But if you don't, you can simply reinvest it in a new five-year CD once it matures.
How much can you make from a CD?
The rate you see advertised is the APY, which reflects how much your CD will grow in one year.
In simple terms, APY tells how much your CD will grow in one year. So a $1,000 CD at a 4% APY can be expected to be worth $1,040 after one year.
Of course, the amount of money you can make depends on a few factors, such as how much you deposit, whether you receive your interest payments or leave them in the CD to collect compound interest, how long your CD's term is, and more. But especially in today's relatively high-rate environment, CDs can be a good means of earning nice returns on your money without taking on much risk.
Is a CD right for you?
A CD can make sense if all these things apply to you:
- You want a higher interest rate than your savings account offers, and/or you want to know what your interest rate will be for a certain time.
- You are reasonably certain that you won't need access to your money until after the CD reaches its maturity date.
- You want to earn strong returns on your money but don't want the risk of investing in stocks or even bonds. And you don't want the hassle of opening another type of account, such as a TreasuryDirect account to buy Treasury bonds.
Sound like a good fit? Check out our list of the best CD rates now to choose which is right for you.
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