Mastering Certificates of Deposit: A Practical Savings Guide
CDs could help you grow your savings over time.
Have you heard the news? CDs are popular again!
No, not the ones that play music. The CDs we’re talking about are Certificates of Deposit. These saving products are making their way back into peoples’ saving strategies because rates are at their highest in over 12 years.1
If you haven’t heard of CDs before, we’ve got you covered with a two-part series to give you a full explanation.
In this first part of the series, we’ll provide an introduction to how CDs work and some of the most common types. Then, in part two, we’ll discuss some of the benefits and tips to help you decide if you should add them to your savings strategy.
CDs are a savings vehicle that tend to offer higher rates in exchange for customers leaving funds in the account for a set period of time.
There are several types of CDs available, each with their own unique requirements and benefits.
You may incur penalties if you try to withdraw funds prior to the maturity date.
What is a Certificate of Deposit?
As we mentioned, CDs are savings products offered by financial institutions that typically pay fixed rates, often expressed as Annual Percentage Yield (APY), over a specified term.
They may offer higher rates than average money market or savings accounts in exchange for a commitment of time (aka term). When you deposit money into a CD, it begins to accrue compound interest until a designated maturity date.
Some people consider CDs to be a useful savings tool and others consider them a type of short-term investment.
As a savings tool, they tend to be less flexible than savings accounts because many CDs restrict withdrawals made before the end of the term.
As an investment, CDs are considered safer than stocks because they lack volatility. CDs aren’t publicly traded and don’t have a share price that moves with the market. Unless you withdraw funds from the CD before the term ends, there is very low risk to the principal balance or rate established when you open the CD.
Additionally, CDs from a chartered bank are backed by the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Administration (NCUA).2 In the unlikely event of a bank failure, the depositor’s CD would be insured up to the maximum allowed by law. Note: Only CDs held at chartered banks are protected by FDIC insurance. CDs opened through credit unions are insured under NCUA.3
As always, it’s important to shop around. Many digital banks offer very competitive high-yield savings account rates. You may find that a savings account can achieve almost the same profit potential as a CD and still give you all the flexibility and access to your money.
Types of CDs
CDs have been a staple in banking products for a long time. They’re popular because they provide a steady rate of return during the contracted term, even if the market fluctuates during that time. Banks like them because the customer is committed to the bank for the length of the CD term.
That said, there are several types of CDs, each offering unique features, benefits, and restrictions. Depending on your financial situation and goals, one type may be a better fit for you than another.
Let’s take a look at some of the most common CD products in the market.
Traditional CDs are the original and most banks who have CDs offer them. Aside from the fancy features offered for other CDs today (we’ll get into those in a second), the basic concept for a traditional CD is pretty simple: deposit money for a fixed term and earn a fixed rate during that term. When the CD term ends, the customer may choose to roll it into another CD and continue the cycle.
It's important to note that traditional CDs often come with penalties for early withdrawal.4 Part of the value proposition is that you usually get a higher rate in exchange for not touching the funds for a specified term.
You may also hear some CDs called “High-Yield CDs”. These products are essentially traditional CDs that offer even higher rates, making them appealing if you’re seeking greater returns on your investment.
A bump-up CD, sometimes called a “raise your rate” CD, is an option that may be beneficial when rates are on the rise.
With this product, you open a CD at a specified rate. As time goes on, if your bank introduces an even higher rate, you’re able to request to "bump up" to that higher rate for the remainder of the term.5
Bump-up CDs require the account holder to request the higher rate, it doesn’t happen automatically, and usually it’s only allowed once.
Also, bump-up CDs typically start with a lower APY than traditional CDs, but there’s no guarantee that a higher rate may become available later on.6 This means you may be stuck with a lower rate than you would have gotten with a traditional CD—it’s a gamble.
Remember those early withdrawal penalties we discussed? No-penalty CDs don’t have those, for the most part.
Like traditional CDs, no-penalty CDs earn a fixed rate for a fixed term, but they also allow account holders to withdraw the funds, including interest earned, without paying a penalty fee.7 Usually these CDs require you to leave the funds in the account for some period of time (shorter than the term), but then they’re available for withdrawal.8
Since these accounts are more flexible when it comes to withdrawing your funds, the rates tend to be lower than traditional CDs because banks have less assurance customers are going to leave their funds in the account for the entire term.
Brokered CDs are sold by brokerage firms rather than banks or credit unions. Brokerage firms often open CDs in bulk and then sell them off as brokered CDs.9
Brokered CDs tend to have higher yields because they are sold in a more competitive marketplace. They may also be more flexible than CDs from a bank or credit union.10
Unlike most investments, brokered CDs are usually still FDIC insured because they are initially issued by a bank.11
Jumbo CDs are specifically designed for people with a substantial amount of funds to invest.
These CDs require a larger initial deposit, typically around $100,000. In return, jumbo CDs typically offer higher rates than traditional CDs.12
Many jumbo CDs are opened through either an investment or brokerage firm.13
Watch Outs for CDs
As you consider your CD options, it’s important to keep the following factors in mind before opening one:
Type of CD: Understand the specific terms, benefits, and restrictions associated with the type of CD you choose.
Minimum Opening Deposit: Be aware of minimum deposit requirements to open a CD, as they vary among financial institutions.
Fees: Some CDs may have fees associated with them, such as maintenance fees or early withdrawal fees. Familiarize yourself with these potential costs.
Penalties: Early withdrawal from a CD typically results in penalties unless you have a no-penalty product. Make sure you understand rules associated with your chosen CD before making any withdrawals. Penalties are usually based on the CD’s term and expressed as a portion of the potential earnings. For example, the penalty on a 3-year CD may be 180 days of interest.
Rates: Compare the rates offered by different financial institutions and over different terms.
Compounding Frequency: Take note of how often interest compounds. Most CDs compound interest daily.
Interest Posted: Note how often interest is posted to your account. While interest may compound daily, it may only be posted monthly or annually. For example, if your interest compounds daily but is posted monthly, you would only see a change in your account balance on a monthly basis, when the interest is posted.
Auto Renewals or Grace Periods: Some CDs automatically renew if the funds are not withdrawn within a certain period. Be mindful of renewal terms and consider setting reminders to review your options.
CDs may be a great way to increase your savings over time, especially if you don’t need access to the funds for a while. If you have additional questions about opening a CD, chat with a financial expert.
Certificates of Deposit may offer a more secure way to save money and grow your funds over time.
Understanding the various types of CDs, their characteristics, and the considerations involved is important before you open one. Evaluate your financial goals, risk tolerance, and the current market conditions to assess if CDs align with your investment strategy.
By doing so, you may be able to make the most of these savings products and work towards achieving financial wellness.