The Other Kind of CD

When you hear CD, you probably think of the pre-digital way of listening to music. Turns out, there is a different type of CD just waiting for you at the nearest bank — the certificate of deposit. With so many banking products available, it can be hard to choose the type that’s best for you. Our guide below will help you decide whether you should add a CD to your finances.

The Basics

A certificate of deposit is a financial product sold by banks and credit unions. They are similar to savings accounts, but your money isn’t available (at least not without a penalty) for immediate withdrawal and accounts normally come with fixed terms and fixed interest rates. Whether the term is a month, six months or even five years, the CD is meant to be held until maturity.

In short, banks and other financial institutions essentially pay you to keep your money on deposit for a specified length of time. Usually, the longer the term, the higher the interest rate. CDs are insured by the Federal Deposit Insurance Corp. (FDIC) or the National Credit Union Administration (NCUA), so they’re virtually risk-free.

How CDs Work

There are many types of CDs, including a traditional version (in which the predetermined interest rate remains the same for the life of the CD) and a bump-up version (in which you are given a one-time option to change the interest rate, should rates generally rise). They often require minimum deposits and earn interest that eventually compounds (meaning that additional interest gets added onto previously earned interest). When you buy a CD, you’ll either receive a paper certificate or an item will show up on your bank statement.

Not all CDs have the same benefits. Rates differ based on the annual percentage yield (APY) and the annual percentage rate (APR). The former is the rate you earn as interest compounds while the latter is the rate you’re charged without taking compound interest into account.

CDs can compound interest yearly, quarterly, monthly or even daily. While you’re shopping around, you might find that CDs from online banks typically have higher rates than those sold by traditional financial institutions.

CD Ladders

One popular strategy is called CD laddering. It involves dividing up your funds and investing equal amounts into multiple CDs with varying lengths. Laddering offers more flexibility and can allow you to maximize your earning potential.

If you wanted to, you could choose a CD with a one-year term, another with a two-year term and a third with a five-year term. After the first one expires, you can reinvest those funds into another CD. Besides increasing your odds of earning more money, a CD ladder can ensure that you have a constant flow of cash available as each CD matures so your money isn’t always all tied up.

The Downsides of Investing in CDs

The biggest drawback of a certificate of deposit lies in the fact that funds cannot be touched until they mature, at least without a penalty. If you take your money out before the agreed-upon length has ended, you will incur an early withdrawal fee.

The fee amount that’s deducted is usually a portion of the earned interest. That can change depending on the CD term and the institution you’re working with. In some cases, the fee may be withdrawn from the principal you originally invested if the interest you’ve earned is lower than the penalty.

It’s important to take note of the fee before you open a CD and especially before you decide to withdraw your funds early. That’s because the loss of interest may outweigh the benefits of having early access to your investment.

Another potential downside of having a CD is that the bank or credit union may need to delay your right to withdrawals (rare, but it could happen). What’s more, if you have a callable CD, the bank can close your investment account before it reaches maturity. If that happens, you could miss out on the chance to earn some extra interest.

Finally, when you’re locking your money away for an extended period, you are betting that the interest you earn will be higher than inflation. This isn’t always true.

The Bottom Line

CDs aren’t for everyone, but they can be a safe way to build wealth (without the risks of being in the stock market) if you have some cash that you know you won’t need for a few months or years. They can be especially useful if you’re approaching retirement or you’re too risk-averse to invest in the financial markets. If you decide to use this investment vehicle, it’s a good idea to do plenty of research so you’re aware of your options.