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?
CDs vs. savings accounts
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 most obvious difference between a CD and a savings account is that you’re committing to leaving your money in the CD for a certain amount of time. CD term lengths generally range from a few months to about five years, although shorter or longer terms may be available. With a savings account, you are free to withdraw your money whenever you’d like. For this reason, a CD is also commonly referred to as a time-deposit account. The ending date of a CD account is known as its maturity date, and the entire account balance is withdrawn when this date is reached.
- Because you’re committing to leave your funds on deposit, banks typically pay higher interest rates on CDs than they do on savings accounts. And, the longer the term of the CD, the higher the interest rate it will typically pay.
- There is generally no such thing as a partial withdrawal from a CD. For example, if you deposit $1,000 into a savings account, you can choose to withdraw a portion of it and leave the rest in the account. With a CD, your withdrawal generally has to be for the entire amount, even if you decide to access your funds before the maturity date and accept a penalty.
How much interest can you get from a CD?
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.
CDs as retirement investments
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.
Is there any risk involved with opening a CD?
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.
What if you need the money sooner?
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:
View more information: https://www.fool.com/the-ascent/banks/how-cds-work/