How Do CDs Work?

If you have some extra cash you can stash in savings for a while, you might want to consider opening a Certificate of Deposit (CD) account. CDs work as a kind of savings account on steroids. They typically earn a higher interest rate than traditional savings accounts, and because you can’t make a withdrawal without penalty for a fixed period of time, CDs encourage you to save.

Certificates Of Deposit Explained

When you open a Certificate of Deposit, your bank or credit union accepts your deposit for a fixed period, called "the term." That term might be as short as 30 days, but is more often for a year, 5 years or sometimes even 10 years. Because funds are deposited for a longer term, the bank pays a higher interest rate. Those rates are based on the federal funds rate, the basic lending rate set by the U.S. Federal Reserve system.

The CD matures when the term is up. At that time, you get back your original investment plus interest. You can withdraw your funds then to use as you wish, roll the funds into a new CD with your bank or transfer the funds to another institution or brokerage account.

The Different Types Of CDs

There are many different types of CDs, and though they each have their unique characteristics, they are more alike than different. Here are the most prominent CD types:

Traditional CD

The traditional, or standard, CD offered through most banks and credit unions offers you a return on your deposit at a fixed rate for a pre-determined period of time. The principal benefit of a CD is that it pays a notably higher annual percentage yield (APY) than a regular savings account. The APY is the rate of return on an investment for one year taking compounding interest into account.

When the CD “matures,” or reaches the end of its term, you can withdraw all of your initial deposit and interest penalty-free. You can withdraw some or all of the funds before the CD matures, but you’ll have to pay a penalty according to the terms of the account.

Ask your bank what your options are when the CD term ends, but typically at that time you can either:

• Close the account and transfer the funds to another account.
• Set up a new CD and send some or all of the funds to seed the new CD.
• Send the funds to another account, such as a new CD, savings account or brokerage account, with another institution.

No-penalty (Liquid) CD

As the name implies, this type of CD allows you to access your funds at any time without a fee. However, it’s set up exactly like a traditional CD with a fixed interest rate and term. Here are the key differences from a traditional CD:

• Offers more flexibility.
• There may be a waiting period at the beginning when you can’t withdraw penalty-free.
• Typically if you withdraw early you’ll have to empty the entire balance.
• Might require a higher minimum deposit.
• Tends to offer a lower APY than traditional CDs.
• Might have fewer term options.

Bump-Up CD

A bump-up CD is a certificate of deposit that allows you to request at least one “bump-up” adjustment to the interest rate if rates rise advantageously before the term limit. Some bump-up CDs even allow multiple adjustments for longer-term CDs. This type of CD capitalizes on rising rates, potentially earning you more. It’s similar to a step-up CD, making it a flexible choice for optimizing savings.

Step-Up CD

A step-up CD works much like a bump-up CD, but it raises the rate automatically if rates rise to your advantage during the term. The principal advantage is that you don’t have to monitor rates and request the bump yourself.

IRA CD

If you have an individual retirement account (IRA), you can invest some of the funds in an IRA CD. It works exactly like a traditional CD, but because the fund exists inside your IRA, you won’t have to pay capital gains taxes on your earnings. An IRA CD provides less risk than other types of investments in your IRA; it therefore diversifies your retirement account and provides dependable, stable income.

CDs From A To Z

Here are some of the key concepts to understand when you go shopping for the most advantageous CDs.

CD Rates

When you keep your money in a bank account, the bank is able to use it to make more money by lending it to others. Banks create CDs because it’s in their best interest to have your money invested with them for an extended period of time—as opposed to the funds you keep in your savings account, which can be withdrawn at any time.

Because of this, banks pay a higher rate of interest if you invest at least some of your savings in a CD. Since having access to more of your funds for a longer period of time is valuable to your bank, rates are typically higher if you make a larger deposit on a longer term CD. Your goal, however, should be to get a CD with the highest yield (higher rate) in the shortest amount of time (shorter term). Rates vary by bank, so shop around for the best rates and/or promotional deals to get the best return.

CD Terms

A CD’s term is the amount of time that must pass before you can withdraw funds without penalty. In exchange for tying up your savings for a longer-term CD, banks will pay you a higher interest rate.

Most terms range anywhere between 3 months and 5 years, though they can go as high as 10 years in some cases. CDs with 3-month, 6-month and 1-year terms are considered short-term CDs, while CDs of 2 – 5 years and more considered long-term CDs.

Maturity Date

A CD’s maturity date is simply when the term limit expires. The account will stop earning interest and you will make a decision on where the funds go next. You can roll the funds into a new CD, transfer them to another account at your bank or credit union or send them to an account at another institution.

Penalties

If at all possible, it’s best to leave your CD alone until its reached maturity because a.) it maximizes your earnings and b.) you’ll avoid paying the penalty for early withdrawal.

Banks set their own penalty fees and they will be in the fine print of the CD agreement. In general the longer the term of the CD, the higher the fee for early withdrawal. The penalty is usually expressed as a number of days of interest earned by the account based on its annual percentage yield (APY).

Penalties are typically around 3 – 6 months of interest for a 1 year CD and 6 months to 1 year for 5 year CDs. To determine the amount of a penalty, you can multiply the amount of interest the CD earns in a day or month by the number of days or months set by the penalty language.

How Do You Open A CD?

Whether you’re opening a CD with your current bank/credit union or shopping for the best deals online, you’ll need some basic information to apply, including:

• A photo ID
• Name, address, phone and email address
• Date of birth and Social Security number

Next you’ll need to decide upon an amount you’re comfortable investing and how long you think you can live without those funds. If you’re transferring funds within your own institution, you can typically do so online or in person with a check. If you’re doing an external transfer you’ll need to know the account and routing numbers for your bank account. Some CDs may have additional steps, so be sure to understand what your financial institution requires before you transfer funds.

How Much Is The Right Amount To Invest?

Only you know your financial goals and the key future dates when you’d like to meet them. Shorter term goals might be a down payment on a house within the next five years, while a longer term goal might be a college fund for kids.

The amount you can invest in a CD really has no limit, but try to anticipate an amount you know you won’t need during the term of the investment. If you’ve consistently had $20,000 in savings for the last two years, for example, can you reasonably expect to invest $10,000 of that for 2 years and not miss it?

An interesting way to spread your investment over time is a CD ladder. With this strategy you invest equal amounts of money into CDs with consecutively increasing maturation dates. For example, you could choose to create your ladder with CDs that mature in 1 year, 2 years, 3 years, 4 years and 5 years. After the first year, if you still do not need the funds, you would reinvest those funds into another 5-year term. When the 2-year CD matures, you would reinvest those funds into another 5-year term, and so on. This would allow you the flexibility of having access to those funds once a year if you needed them while also taking advantage of the benefits of a longer CD term.

The Bottom Line: CDs Are Good Investments

A certificate of deposit (CD) is a great financial tool especially for young investors who are ready to begin building wealth by making better use of their savings. If you can set aside some money for a year or two in a CD, you can see how higher rates of return can grow your bottom line exponentially. Before investing, it’s a smart idea to talk to a financial advisor or other financial professional to understand the best options for your money.

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