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As inflation re-enters the economic picture and interest rates are on the rise, investments like Certificates of Deposits (CDs) have regained their importance in investment portfolios. But what exactly are CDs, and how do CDs work? CDs are time-bound savings tools provided by banks or credit unions, promising a fixed return, but there is much more to them than at first glance. This article will explore the intricacies of CDs - how to buy them, maturity dates, potential penalties, types, and their comparison to other savings tools. Let’s boost your savings smartly by learning below.
How do CDs Work?
Even though many are familiar with investing, you may have questions like “how do CD accounts work,” or “how do CDs work at banks.” First, note that a CD is a financial product that banks and credit unions offer their customers. It is an agreement where you give your (hard-earned!) money to a financial institution, promising them that you will not withdraw it for a certain period. The time you promise not to withdraw can range from a few months to several years, known as the “term” of the deposit.
So how does CD interest work, and how do CDs work at banks? The bank promises to pay you a fixed interest rate on your deposit, typically much higher than what you might get from a regular savings account. Of course, the main drawback is that CDs are time-bound, meaning you can’t deposit or withdraw at will like in a regular savings account, at least without a penalty. It is part of what allows banks to offer those higher interest rates because they can use your money for longer, giving them more flexibility to loan it out themselves.
CDs are also insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000, making them an essentially risk-free way to grow your savings. If you remember, in 2023, several banking institutions collapsed (like the Silicon Valley Bank, for example), but if you held a CD with that bank up to $250,000, you would not have to worry as the FDIC guarantees them.
CDs can be an effective part of a diversified savings or investment strategy, particularly for conservative investors who need guaranteed returns over higher-risk investments. With current rates hovering around and above 5%, the return is quite attractive.
How to buy a CD - A Step-by-step guide
If you’re looking into how to buy a CD or how does CD interest work, below will be a step-by-step guide to help you.
- Research CD options: Investigate the available options. You would think that all would be the same. However, there is generally a difference in rates and terms across banks and credit unions. Do your research before locking in.
- Decide on a term: Consider how long you want to lock your funds in. It could be six months, a year, or even five years if you really don’t need the money. The duration will impact what rate you can get, with longer terms generally offering higher rates.
- Determine your investment amount: While most banks will have a minimum amount you will need to hit, ensure you choose the amount you are comfortable locking in. Once you commit, you cannot access the funds without incurring a penalty - which is usually significant - until that CD matures.
- Open a CD account: After these steps, open a CD account with your chosen institution. The process will differ slightly between institutions, but it generally involves collecting some personal information, agreeing to terms and conditions, and depositing your initial amount.
- Wait and earn: Once the funds have been deposited and invested, you’re earning interest. Interest will accrue over the term; at maturity, you’ll have the initial amount deposited plus the interest earned.
One suggestion to make is to read the fine print! Things happen in life; if you need to make an emergency sale, you should know what you are getting into. Be comfortable with all terms before purchasing a CD.
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What is CD Maturity Date
The term “maturity date” refers to the fixed date when the term of the CD ends. It’s the time when the money you deposited, plus the accrued interest, becomes accessible without penalties.
For example, if you purchased a 24-month CD on July 6, 2023, your maturity date will be July 6, 2025. On that date, you will receive your initial purchase amount plus earned interest, which you can use freely.
CD Penalty
CDs hold your investment locked in for a set period. However, if you find yourself needing to withdraw the money before the term ends, it is still possible - but only with a penalty. There is usually a clause in all CDs known as an early withdrawal penalty, which can be substantial and can eat into much of the interest you’ve earned or even your initial deposit amount.
The exact penalty amount varies depending on the institution and term length of the CD, but it is common practice to see penalties equating to several months’ worth of interest earned.
For example, if you have a one-year CD, the institution may charge a penalty equal to 3 months of interest for an early withdrawal. This is why you need to read the fine print and be sure you are comfortable with the term of deposit before committing to a CD, as early withdrawals significantly affect your returns.
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Types of Certificates of Deposit
There are several types of CDs; listed below are some of the most common.
- Traditional CDs: This is the most common type of CD, where you invest a fixed sum of money for a predetermined period. It could be five months, one year, or five years, earning a fixed interest rate on that amount throughout the term.
- Bump-up CDs: These are more flexible and allow you to increase your rate once or twice if rates rise during your locked-in period. This can provide a hedge against rate fluctuations.
Liquid CDs: As the name implies, these CDs offer greater liquidity than traditional CDs. In general, they allow you to withdraw some of your money without penalty, which could be useful for those with more uncertainty in their cash flow needs. - Zero-coupon CDs: These CDs are unique because they pay out interest only as the CD reaches maturity. Interest earned is automatically reinvested, leading to a higher compound-interest rate.
- Callable CDs: The issuing institution holds the right (but not the obligation) to “call” or terminate a callable CD after a set period. You would receive your initial deposit and interest earned up to that point. This mainly benefits the institution, as they can call the CD if market interest rates fall.
Each of these types comes with its own features and benefits catering to differing situations and investment objectives. When figuring out the answer to “how do CDs work at banks,” consider which type best aligns with your specific savings goal and cash flow needs.
Advantages and Disadvantages of Certificates of Deposit
There are several pros and cons to CDs, especially for conservative savers.
Advantages:
- CDs provide a higher interest rate than most traditional savings accounts, allowing your money to grow faster.
- There is a large degree of safety, even risk-free investing, as the Federal Deposit Insurance Corporation (FDIC) insures them for up to $250,000 per depositor, per bank.
Disadvantages:
- The major disadvantage is that CDs generally lack liquidity. Once you deposit your money, accessing before the maturity date is typically prohibitive.
- Early withdrawals can lead to hefty penalties.
- The interest rate for traditional CDs is not variable. If market rates rise, you miss the opportunity to obtain higher rates.
While CDs are a safe tool for steady growth, they lack the flexibility of other investment options. Ensure you do your due diligence before investing.
Risks of CDs
While CDs are safe investments due to FDIC insurance, risks remain, as noted below.
- Interest rate risk: This is the most notable risk with CDs. If you lock your money into a CD when interest rates are low and rates subsequently rise, you miss the opportunity to earn higher interest rates before that holding matures.
- Early withdrawal penalties: Accessing your funds before maturity can result in early withdrawal penalties. This cost can be significant, and in some cases, you may lose part of your initial deposit.
- Inflation risk: If the inflation rate exceeds the interest rate on your CD, the purchasing power of your investment could decrease over time. This is known as locking in real losses (as opposed to nominal losses) in purchasing power.
How to Choose the Right Certificate of Deposit
Choosing the right CD for you involves assessing your financial goals and timeline. Determine how long you can spare your money for the proper term length, compare interest rates, and consider a liquid CD if there is even a remote chance you will need early access to your funds. Despite a lower interest rate, the flexibility provides for unforeseen needs.
CD vs. other savings tools
CDs, savings accounts, money market accounts, and stock market investments all serve different financial needs and goals. Unlike the savings account, for example, which is flexible, a CD requires you to lock in your funds for a specific period - but it offers a higher interest rate. Money market accounts offer more accessibility than CDs, but often require higher initial deposits and minimum balance amounts. While they may offer competitive interest rates, they tend not to be as high as a CD.
The stock market, in contrast, offers potentially higher returns but with more significant risk. Unlike CDs, the FDIC does not insure stocks and stock market investments, meaning you can lose your initial investment. While CDs may not have the high potential returns of the stock market, they provide a safer, more predictable way to grow your savings.
Conclusion
Certificates of Deposit are a great tool to use in many savings strategies. Current rates are attractive and are much higher than traditional savings accounts. The safety of FDIC insurance gives another peace of mind addition to your investment. However, their value depends on your individual financial situation and goals. Consider the associated risks, like early withdrawal penalties and fixed interest rates, when considering CDs for your portfolio.
FAQ
What is a certificate of deposit (CD)?
A CD is a type of savings account that holds a fixed amount of money for a fixed term (period), from a few months to several years. In return, the issuing institution pays interest to the holder.
How much should you invest in a CD?
The amount to invest in a CD depends on your financial goals and objectives, the CD term, the interest rate, and how much you can invest without needing access to the funds for the set term. Maintain enough liquidity to cover any potential financial emergencies outside of your investments.
Can You Lose Money in a CD?
While possible, it is unlikely to lose your initial deposit in a CD, as they are FDIC insured. However, you can lose accrued interest or even some principal if you withdraw your money before maturity.
Do CDs Pay Interest Monthly?
Interest schedules vary on CDs. Some compound and pay out monthly, quarterly, annually, or only at maturity. These terms will be laid out in your agreement when you open a CD account or investment.
Article Topics
Certificate of Deposit
Matthew is a freelance financial copywriter with 14+ years in financial services. He holds a Bachelor of Science degree in Economics with business and finance options and is a CFA Charterholder. He is from Vancouver, Canada, but writes from all over the world.
