Definition and Examples of a Certificate of Deposit
A certificate of deposit is an account in which you place funds and commit to leaving them in the account for a set period called a term. In turn, the institution pays you a higher interest rate than you’ll find in a typical savings account.
- Alternate name: Time deposit account
- Acronym: CD
For example, Bank of America (B of A) offers certificates of deposit with terms between 28 days and 10 years. B of A lets you open a CD with $1,000 and offers rates of up to 0.05% depending on the CD you choose.
How a Certificate of Deposit Works
A certificate of deposit works precisely like a savings account, except that you agree not to access the funds in the account until the maturity date. Once you commit the funds, the bank places your money into the account and pays interest to the account. If you need to withdraw your funds before maturity, many banks will charge you an early withdrawal fee.
When the CD's term ends, you can take your money penalty-free by transferring it to a regular bank account. Alternatively, you can choose to reinvest it. Some banks even offer you the choice for automatic reinvestment into a new CD.
Note
You can open up multiple CDs and use a CD ladder strategy to stagger maturity dates and get higher interest rates on some of your money.
A CD makes it easy to get a higher and more stable return on your savings and provides multiple options when the term ends. You deposit a lump sum of cash for a term that can last a few months to several years. In return, your bank or credit union pays interest at a fixed or variable rate. Typically, you can’t put more money in after opening the account.
Minimums and Maximums
Credit unions and banks require a minimum deposit—such as $1,000 or $2,500—to open a CD. You can choose from whatever term lengths are available, and you can expect interest to accrue and compound as long as the funds remain in the account.
CDs typically don't have a maximum amount you can deposit. For example, Bank of America CDs allow deposits of more than $1 million.
Note
The Federal Deposit Insurance Corporation and National Credit Union Administration insure up to $250,000 in deposits (including CDs) per depositor, per insured bank or credit union.
Types of Certificates of Deposit
In addition to traditional CDs, you’ll find versions that have features such as more liquidity, flexibility for adding funds, or the ability to benefit from interest rate changes. Some of the many options include liquid, add-on, step-up, and IRA CDs.
Liquid CD
Sometimes called a no-penalty CD, a liquid CD is a good choice when you expect to need your money early, or you want the option to reinvest your money whenever you see a better opportunity. Generally, there is a waiting period before you can withdraw your funds, such as six days.
Note
Liquid CDs usually have short terms that aren’t much more than one year. The downsides are that you often get a lower rate with this flexible CD option, and your bank might prohibit withdrawals before seven days.
Add-On CD
If you don’t like the idea of a one-time deposit, an add-on CD gives you the option to deposit more funds to increase your earnings. You might be able to set up recurring deposits; there may be a minimum amount for each deposit, or the bank may require the funds to come from another account you have through them. This type of CD is likely to have lower interest rates and opening deposit requirements.
Step-Up CD
A step-up CD prevents you from being stuck with a single interest rate. That way, you can benefit from rising market rates without needing to withdraw your money and reinvest it elsewhere. Generally, this type starts with a low interest rate which increases once or periodically throughout the term. However, you may not benefit if market rates don’t go up.
IRA CD
Rather than putting your annual IRA contributions into bonds and stocks, you can choose an IRA CD—these retirement tools reduce risk to your capital because CDs are generally safer than stocks and bonds.
Note
If you withdraw your money from an IRA CD early, you could pay tax penalties as well as lose interest payments if you remove it before you reach the minimum retirement age.
If you make contributions with pre-tax dollars, you can defer your taxes and even deduct contributions if you qualify. Roth IRA CD contributions can allow for tax-free withdrawals during retirement as long as the account is five years old. A traditional IRA CD lets you make withdrawals penalty-free after turning 59 ½.
Pros and Cons of Certificates of Deposit
Pros
Steady return
Higher rates than other savings accounts
Many options available
Safety through deposit insurance
Cons
Liquidity limitations
Lower return than riskier investments
Early withdrawal penalties
Inflation risk
Income taxes on earnings
Pros Explained
- Steady return: Fixed-rate CDs offer a guaranteed return; variable-rate CDs offer changing rates but stable returns. In general, CDs have more predictable returns than other investment types.
- Higher rates than savings accounts: Very short-term CDs can have interest rates similar to savings accounts. However, CDs with a term of at least six months generally have higher rates than savings accounts.
- Many options available: You can choose from one of the many CD types that fit your needs, compare rates, and consider any incentives offered to maximize your interest earnings.
- Safety through deposit insurance: Whether you choose a credit union or bank for your CD, it is insured up to the maximum insurable amount. Therefore, your principal won’t be at risk like money put into stocks, bonds, or mutual funds would be.
Cons Explained
- Liquidity limitations: Depending on the CD term, your money could be held up for several years.
- Lower return than riskier investments: CDs have lower returns than other investments because less risk is involved.
- Early withdrawal penalties: Unless you’ve got a liquid CD, you can expect to lose interest earned on your CD’s principal if you need to make an early withdrawal.
- Inflation risk: Even interest rates on high-yield CDs may not be able to keep up with inflation.
- Income taxes on earnings: The IRS makes CD interest income taxed at your income tax rate. This extra tax burden can cut into your returns if you have a high income.
Alternatives to a Certificate of Deposit
If the various types of CDs don’t offer what you need, you might benefit from other options. While you might not get as high of a return, you’ll have quicker access to your funds and the option to add to your investment at any time. Money market, basic savings, and high-yield savings accounts are some choices to consider.
Money Market Account
While designed for saving, a money market account has some similarities to a checking account. For example, some accounts allow you to write checks. In addition, the interest rate earned can compete with that of certain CDs, but it may depend on your account balance.
Low-Yield Savings Account
Although they tend to offer the lowest interest rates, low-yield savings accounts are easy to get and usually have a low minimum deposit for opening the account. You get on-demand access to funds for deposits and withdrawals whenever needed, but you don’t get the checking account similarities a money market account has. Your financial institution may charge a monthly account fee plus fees for excessive withdrawals.
High-Yield Savings Account
Sometimes offering interest rates similar to a CD, a high-yield savings account is a higher-earning alternative to a basic savings account. These accounts are flexible for deposits and withdrawals, so there’s high liquidity. However, they can require a high minimum balance to earn interest or benefit from the top-tier rate. You can look for online high-yield savings accounts to score more competitive rates and find options without fees or minimum balance requirements.
Key Takeaways
- You initiate a CD by setting aside a sum of money for an agreed-upon period.
- You can find CDs with varying term options and interest rate structures as well as select varieties such as liquid, step-up, add-on, and IRA CDs.
- You benefit from low risk with a CD since earnings are more predictable. Your account is often federally insured, and you could get emergency access to the funds with an early withdrawal penalty.
- CDs usually offer a return that beats traditional savings accounts but doesn’t surpass investments like stocks and bonds.
- When a CD’s term expires, you have control over whether you withdraw your balance or continue the investment.
About Certificates of Deposit
As an enthusiast with a deep understanding of financial instruments, I can confidently provide comprehensive information about certificates of deposit (CDs). A certificate of deposit is an account where you deposit funds and commit to leaving them for a specific period, known as the term. In return, the financial institution pays you a higher interest rate than what you would typically find in a regular savings account. CDs are also known as time deposit accounts and are offered by banks and credit unions.
How a Certificate of Deposit Works
A certificate of deposit functions similarly to a savings account, with the key difference being that you agree not to access the funds until the maturity date. If you need to withdraw your funds before the maturity date, many banks will charge you an early withdrawal fee. However, once the CD's term ends, you can withdraw your money penalty-free or choose to reinvest it. Additionally, you can use a CD ladder strategy to stagger maturity dates and potentially earn higher interest rates on your funds.
Minimums and Maximums
When opening a CD, financial institutions typically require a minimum deposit, such as $1,000 or $2,500. There is usually no maximum limit for deposits, and interest accrues and compounds as long as the funds remain in the account. It's important to note that the Federal Deposit Insurance Corporation (FDIC) and the National Credit Union Administration (NCUA) insure up to $250,000 in deposits per depositor, per insured bank or credit union, including CDs.
Types of Certificates of Deposit
In addition to traditional CDs, there are various types of CDs available, each with unique features to suit different financial needs. These include:
- Liquid CD: Also known as a no-penalty CD, it offers flexibility for early withdrawals with a waiting period before funds can be withdrawn.
- Add-On CD: This type allows you to deposit additional funds to increase your earnings, and some may even allow recurring deposits.
- Step-Up CD: With a step-up CD, you can benefit from rising market rates without needing to withdraw your money and reinvest it elsewhere.
- IRA CD: These are retirement tools that reduce risk to your capital and offer tax advantages compared to traditional CDs.
Pros and Cons of Certificates of Deposit
Pros:
- Steady return: Fixed-rate CDs offer a guaranteed return, providing more predictable returns than other investment types.
- Higher rates than savings accounts: CDs generally offer higher rates than savings accounts, especially for terms of at least six months.
- Many options available: There are various CD types to choose from, allowing you to maximize your interest earnings.
- Safety through deposit insurance: CDs are insured up to the maximum insurable amount, providing safety for your principal.
Cons:
- Liquidity limitations: Depending on the CD term, your money could be tied up for several years.
- Lower return than riskier investments: CDs have lower returns than riskier investments due to the lower level of risk involved.
- Early withdrawal penalties: Except for liquid CDs, early withdrawals may result in the loss of interest earned on the principal.
- Income taxes on earnings: CD interest income is taxed at your income tax rate, potentially reducing your returns if you have a high income.
Alternatives to a Certificate of Deposit
If CDs don't offer what you need, there are alternative options to consider, such as money market accounts, low-yield savings accounts, and high-yield savings accounts. Each of these alternatives has its own features and benefits, providing quicker access to funds and the option to add to your investment at any time.
In conclusion, certificates of deposit offer a low-risk way to earn a steady return on your savings, with various types and terms available to suit different financial goals and needs.
