How Do CDs Work? Everything You Need to Know

A certificate of deposit, often referred to as a CD, is a specialized savings account. Unlike standard savings accounts, CDs come with set terms, including specific interest rates and time frames. Once you put your money into a CD, you can’t withdraw these funds without facing penalties until the end of the term. You also can’t deposit additional funds.

Keep reading to find out what a CD account and how it works.

How Do CDs Work?

When opening a CD, you agree to let the bank keep your money for a set period of time. At the end of this timeframe, the bank agrees to return your money plus a set amount of interest. There are several factors to consider when choosing a CD, including:

CD Rates

Interest rates are one of the first factors you want to consider when comparing CDs. You also want to know how these interest rates are calculated. For instance, some banks use the annual percentage yield (APY) method to calculate interest on an annual basis, while other banks compound interest monthly.

CD Terms

CDs are available in a wide range of terms. For example, you can open a CD with a term as short as 3, 6, 12, or 24 months. You can also find longer-term CDs that range from 3 to 6 years. Keep in mind when choosing the term that you can’t withdraw money from a CD until the end of the term without incurring penalties.

CD Fees and Penalties

Typically, there are no fees for opening a CD, but there may be minimum deposit requirements. All banks charge some type of penalty for withdrawing your CD funds early. In most cases, penalties are based on a percentage of the interest accrued.

How Are CDs Rates Determined?

Most banks and credit unions use some type of index rate, such as the federal funds rates, to determine interest rates for their CDs. If you’re opening a traditional CD, it will have a flat interest rate that remains the same throughout the term of the account. With this type of account, you know exactly how much you’ll receive at the end of the term.

Are CD Rates Going Up?

When investing in CDs, it’s important to keep an eye on interest rates. This step can help you know when it’s a good time to buy CDs. For instance, when rates are on the rise, it’s likely a good time to invest in CDs. In 2023, interest rates are on the rise, and considering the ongoing inflation concerns, it’s a trend that’s not expected to end anytime soon.

CD Rates Right Now

Interest rates right now are at their highest level since 2008, which makes it an ideal time to consider opening a CD. The latest hike to the federal funds rate in September 2022 brought interest rates to a range of 3% to 3.25%.

Promotional CD Rates

If you’re looking for a deal, you may want to consider investing in promotional CDs. Banks and credit unions often offer special deals for CDs with unusual terms, such as a 7-month term. This may allow you to open a CD with lower minimum deposit requirements or one with higher interest rates.

Are CDs Safe?

When investing in CDs from a bank or credit union, these funds are protected by the Federal Deposit Insurance Corporation (FDIC) up to $250,000. This protection means that if something happens to the bank where your CD is located, you still get your money back as long as you have $250,000 dollars or less. This makes CDs just as safe as your money in a savings or checking account.

Where Can I Get a CD?

You can open a CD at many different financial institutions, including banks and credit unions. You also have the option of going through a brokerage company, which may be able to help you find the best CDs for your specific situation.

How Are CDs Taxed?

You do need to pay taxes on interest earned through a CD. The IRS treats this interest as ordinary income. This means that you must include it with your wages and other forms of compensation. Therefore, the taxes you pay on CDs depends directly on your specific filing status and tax bracket.

What Happens to My CD at Maturity?

Near the end of the term for your CD, your financial institution will notify you and explain your options. You can either simply cash out your CD and transfer the money and interest to another account or reinvest the funds into another CD.

CD Strategies

If you’re looking to maximize your investment in CDs, you may want to consider using one of the following strategies.

CD Ladder

When using the CD ladder strategy, investors split their investments into equal portions. They then spread these smaller investments over several CDs with varying term limits, such as 1, 2, 3, 4 and 5 years. For instance, if you want to invest $10,000 in CDs, you can open 1-year, 2-year, 3-year, 4-year and 5-year CDs, each with a $2,000 deposit.

Each term represents a rung of the ladder. As each CD matures, you can either cash it in or reinvest it into a 5-year term. By reinvesting, you continue to extend the length of your ladder and grow your investment.

CD Barbells

The CD barbell strategy is ideal for those hoping to use CDs as both long- and short-term investments. You still split your investment, with one portion going towards a short-term CD and the other toward opening a long-term CD. For instance, if you want to invest $10,000, you can open a 9-month CD with $5,000 and a 6-year CD with the other $5,000.

CD Bullet

You can use the CD bullet strategy to help meet specific goals. For instance, let’s say you want to have enough for a down payment on a home in 10 years. You’d invest a portion of your money now on a 10-year CD. The following year, you’d invest more money in a 9-year CD, and so on. With this method, all the CDs would mature at the same time.

Alternatives to Certificates of Deposit

CDs are commonly compared to savings accounts, money markets and bonds. Each type of savings method has its own set of advantages and disadvantages you should consider when choosing your options.

CDs vs. Savings Accounts

The benefit of a CD over a savings account is that CDs typically offer higher interest rates. The downside is that you can’t withdraw your money without facing penalties until the end of the term. Savings accounts, on the other hand, typically allow you to make numerous deposits and withdrawals per month. However, some banks do require you to have a minimum balance to qualify for interest.

CDs vs. Money Market Accounts

Money markets are similar to savings accounts. Although some money markets have withdrawal limits, you still have access to a portion of your fund without penalties. The downside is that interest rates for money markets are variable and oftentimes lower than CD rates.

CDs vs. Bonds

While CD term limits can extend 10 years or more, the terms for bonds can be as long as 30 years. However, you can often earn higher interest rates on a bond. The downside is that since a bond is really a loan to the government or a company, you can’t request your funds early. The only option you have is to sell your bond.

Should I Open a CD?

Whether you should open a CD depends on your specific situation. Some reasons to purchase a CD include:

Pros

Pros of opening a CD include a set interest rate that’s usually higher than savings accounts and money market accounts pay.

Cons

The drawbacks of purchasing a CD are that you won’t have access to your money for a set term. If an emergency occurs and you need that money, you’ll pay a penalty to withdraw it. If you need easy access to your money, a savings account may be the better option.

Open an Account Today

Whether you’re considering investing in a CD account, savings account, money market, or bond, the important thing is to compare your options. Make sure you know how much you can afford to put into a long-term account versus a savings account that gives you easy access to your money.

Don’t let your savings sit in an account that’s not accruing interest. Open a savings account today.

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