Everything You Need to Know About Certificates of Deposit

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A certificate of deposit (CD) is a special type of savings account that you can get through a bank or credit union. Unlike a traditional savings account, however, CDs require you to keep your cash in the account for a set period of time until the account matures. For this reason, CDs are sometimes called time deposits.

A CD may provide higher interest rates than a savings account, but they typically require you to give up access to that money in exchange. Here's what you need to know about CDs and whether you should open one.

How Does a Certificate of Deposit Work?

A CD allows you to invest a set amount of money for a period of time with a bank or credit union—say, six months, a year, five years or sometimes even longer. In exchange, the financial institution pays you interest, often at a higher rate than if you were to open a traditional savings account.

When the predetermined period ends, the account matures, and you receive the initial amount you saved plus the accrued interest. If you withdraw money early, the bank or credit union may charge a penalty.

Depending on your needs, there are several different types of CDs available to you. Beyond the traditional setup, here's a quick summary of other options:

  • Bump-up CD: One of the risks of locking in an interest rate over the course of several years is that interest rates can increase over time, leaving you earning less than what you could have otherwise. With a bump-up CD, you can unlock your rate and convert it to the current market rate. You may be limited on how many times you can do this, though.
  • Step-up CD: Similar to a bump-up CD, a step-up CD lets you earn higher rates during the term of the account. The difference is that a step-up CD automatically increases your rate at predetermined intervals—say at seven, 14 and 21 months.
  • Liquid CD: One of the drawbacks of a traditional CD is that you can't access your cash without penalty—in other words, it's not liquid. With a liquid CD (also sometimes called a no-penalty CD), you can withdraw money from the account before it matures, and you won't have to pay a fee to do so.
  • Jumbo CD: This type of CD tends to offer a higher interest rate than a traditional CD but requires you to deposit a large amount of money (typically $100,000 or more).
  • IRA CD: You can open one of these within an individual retirement account (IRA) and take advantage of some of the benefits associated with an IRA, including tax-deferred or tax-free growth.

As you compare the different CD options, keep in mind that accounts with special features may have lower rates or other features that differ from a traditional CD. Be sure to consider all of the aspects of each option before you choose one.

How Is a CD Different From a Savings Account?

As you compare CDs and savings accounts, there are some important distinctions between the two options.

With a savings account, you can access your money whenever you want to, although you may be limited on how many transfers or withdrawals you can make each month. A savings account also typically doesn't charge fees and will have a low balance requirement, if it has one at all. That said, savings accounts typically offer low interest rates, and if the market interest rates change, the rate on your account can too.

Savings accounts are best for people who want to maintain easy access to their funds and aren't concerned with giving up a higher interest rate for that liquidity.

In contrast, a CD may offer a higher interest rate than a savings account, and unless you have a bump-up or step-up CD, you don't have to worry about your rate changing during the term of the account. But the penalty for early withdrawal with most CD types means you won't have easy access to your money.

What Are the Benefits of a CD?

A CD isn't right for everyone, but there are some advantages that can make it worth considering for your own finances.

  • Higher interest rates than a savings account: Interest rates on a CD can vary based on the type of CD and the term. But for comparison, the average interest rate for a 12-month CD is more than five times that of a savings account, according to the Federal Deposit Insurance Corporation (FDIC).
  • A guaranteed rate of return: If you want to keep your money safe for something specific, such as a home down payment or family vacation, putting the cash in a CD is much less risky than investing it in the stock market.
  • Federally insured if opened with the right institution: If you open a CD account with a bank insured by the FDIC or a credit union insured by the National Credit Union Administration (NCUA), your money is insured for up to $250,000 per institution and account type. So if you have $250,000 in a CD with a bank and $250,000 in a CD with a credit union, you'll be insured for the full $500,000.

What Are the Disadvantages of a CD?

Despite offering some appealing benefits, CDs have some drawbacks you should consider before you open one.

  • Early withdrawal penalty: Unless you have a liquid CD, you'll be slapped with an early withdrawal penalty if you take out money before the account matures. This makes CDs a poor choice if you think you'll need the money during the account's term. The penalty amount depends on the term of the CD, but it's typically based on the account's interest. For example, a five-year CD may have a penalty of 18 months' worth of interest.
  • Earns less than stocks and bonds: A CD is less risky than an investment in stocks and bonds. But if you're looking to maximize your gains, you'll likely get a better return with the latter two options depending on how long you plan to let your investment grow and economic conditions during that time.

Should I Open a CD?

For many people, the benefits of a CD likely don't make up for its drawbacks. According to a Bankrate survey, 40% of Americans don't have $400 to cover an emergency expense, so it may be challenging to set aside cash for a set term without the ability to dip into it without penalty.

But if you have a sizeable amount of money sitting in an account, you don't anticipate needing it for a while and you want to minimize your risk, a CD could be a solid alternative to a traditional savings account or stocks and bonds.

As you consider your options, think about your financial situation, as well as your goals. If you have any hesitation at all about liquidity issues, it may be better to consider a high-yield savings account from an online bank, which can offer a better rate than a savings account from a traditional bank instead.