What Are Certificates of Deposit (CDs)?
CDs allow you to save your money at higher interest rates for a fixed period. Learn how they work and their pros and cons here.
Traditional savings accounts offer a safe place to place your money, but they don’t provide much return on your investment. However, other savings options allow you to earn more as your cash sits. Certificates of deposit, or CDs, allow you to save a lump sum for a fixed period at a high-interest rate.
CDs are typically an effective and safe short-term investment option. This article will help you understand how they work, as well as the pros and cons of depositing your money into them. This way, you’ll be closer to making an informed decision on whether they’re right for you.
How CDs Work
A certificate of deposit (CD) is a type of savings account that holds your money in place for a short period in return for a higher interest rate. The duration depends, but it can often be anywhere from six months to five years. You must keep your funds within the account until it matures to maximize your interest and avoid penalties for early withdrawal. After the duration is over, you’ll receive your principal investment, plus any interest it earned.
CD interest rates aren’t always the same. Typically, they’re dependent on several different factors, such as how much you deposit and how long you hold your money in the account. Here’s a full breakdown of what could impact how much your cash earns in the account:
- How much money you initially contribute. Depositing more initially tends to result in higher interest rates.
- Term length. The longer you hold your money in the account, the higher the interest rate typically ends up being.
- Whether it’s insured or not. When your funds aren’t FDIC- or NCUA-insured, they may end up earning more interest.
- Bank size. Smaller banks or financial institutions may offer higher interest rates than bigger ones.
- Account type. Which one you choose can affect your interest rate. For instance, jumbo CDs tend to earn higher returns. Personal accounts may also receive more than, say, a business one.
- Federal funds rate. Financial institutions tend to raise the annual percentage yield (APY) on their accounts if the government raises its funds rate.
While the factors above apply to any company, interest rates will vary depending on the bank you choose. Before you open an account, you’ll want to do some comparison work to find the best situation, or you could risk missing out on extra returns. Keep in mind that if you decide to invest in a CD with the same bank as your other accounts, the FDIC will only insure up to $250,000 across all of your accounts.
As you go to open a CD, you’ll normally have to deposit a minimum amount. Like with interest rates, this can vary based on the bank. Below is a table listing the top five banks in the United States based on total assets, as well as their account minimums:
Types of CDs
There are several types of CDs you can invest in. Each has unique characteristics, such as interest rates, minimum deposit, and duration. Which one you choose depends on your needs and financial goals. However, be aware that not all banks offer every type. With this in mind, these are the most common variations:
- Traditional. These are typical CDs. They allow you to deposit funds at a fixed interest rate for a set period.
- Jumbo. These operate much like a normal account; however, they require a much larger minimum deposit in return for higher rates than a normal account.
- Step-up. With this type, the interest rate will rise if the bank raises it during the term. Bump-up CDs, another variation, allow you to pick when you want rates to go up, rather than wait for the bank to do so.
- Liquid. This form allows you to withdraw funds early without penalty.
- High-yield. Smaller financial institutions (or those that operate online) may offer CDs with a higher APY than bigger ones.
- Callable. In this case, the bank may close your CD at any point and pay you your initial investment, plus any interest it earns. However, with this type typically comes a higher APY.
- Add-on. These give you the ability to deposit more funds during the term’s duration.
Taxes on CD Earnings
Each year, the money you earn from interest with your CD is taxable as ordinary income. Michael Ashley Schulman, a CFA with Running Point Capital, warns that “you’ll pay taxes annually for quite some time on income you can’t access.” Whether you can pay what you owe is a consideration you should make before deciding to open one of these accounts.
Schulman points out that “deciding between a 1-year, 5-year, and a 10-year CD, or any other term, is as much a budgeting question as it is an income question.” This is in large part due to the taxes you’ll need to pay, but also because you need to know if you’ll need the cash in the account sooner. Before opening an account, be sure to think carefully about when you’ll need to withdraw your funds, so you don’t end up taking an early penalty.
Pros and Cons
CDs are often beneficial for investors because of their safety and high interest rates. However, they don’t come without their downsides. For example, they are an illiquid investment and can put you in a precarious position because of their tax obligations. Below, we list the pros and cons you should think about before deciding to open one:
- Safe investment – most CDs are FDIC insured up to $250,000.
- Fixed income due to interest rate
- Higher APY than a typical savings account
- Near guaranteed income – much like a bond, you can reasonably expect to receive your principal, plus interest once a CD matures.
- Must pay taxes on annual interest earnings.
- Opportunity cost/lower returns
- Inflation can lower the purchasing power of funds in the account.
Who Should Open a CD
With their benefits, CDs may seem like an attractive way to save and earn more. However, some people should consider using one of these accounts more than others. The decision to open one is largely dependent on your financial goals and current situation (as most require a minimum deposit).
According to Schulman, a CD might be a good choice if “you have a lump sum of money that you won’t need for a specific period and you’re comfortable with locking in your funds for a set term.” In other words, you’ll need to make sure you don’t miss the money you put away because you won’t be able to access it.
Even with their high interest rates, CDs don’t offer huge returns for investors. For this reason, they’re typically more appropriate for the short term. So, if you’re someone who’s looking to save up for something like college or buying a house, yet you only have a few years to do so, you may consider putting your money in one of these accounts.
Everyone’s situation is different, however. If you’re trying to decide whether opening a CD is right for you, we recommend speaking with a financial advisor for advice. They’ll be able to help you figure out which investment or savings vehicle best matches your goals.
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Frequently Asked Questions
Are certificates of deposit worth it?
This largely depends on your goals and current financial situation. If you’re looking for near-guaranteed returns in the short term, a CD may be worth it. However, be aware that you’ll need to be comfortable with not touching the money in it for the entire term length.
Is a CD FDIC-insured?
Most CDs are FDIC-insured up to $250,000. Some, however, may not offer this protection. Typically, ones that aren’t insured offer higher interest rates to help balance the risk for accountholders.
How safe are certificates of deposit?
CDs are one of the safest types of investments you can make, especially if your funds are FDIC-insured. However, there is still some risk because a given financial institution could somehow go out of business and lose your money. Schulman recommends you “take extra care regarding the reputation and financial stability of the bank, credit union, or other financial institution you are dealing with to ensure the safety of your investment.” For instance, while smaller banks may offer higher rates, a larger one might carry less risk of losing your money.
How are CDs taxed?
Annual interest earnings are taxable as ordinary income. This is a consideration you must make before you put funds into a CD. Be sure that you’re able to pay taxes as they come, as you won’t be able to touch what’s in your account until the maturity date.
What are some alternatives to CDs?
There are a few alternatives to CDs you can and should consider. Per Schulman, “money market accounts, savings accounts, and government bonds (T-Bills and Treasuries)” are all other options you might consider. And, according to him, “if you seek easy access to your money and want to be able to write checks or make withdrawals, a money market account might be a better choice.”
Government bonds, or T-Bills, may also be a smart choice if you’re worried about paying taxes on earnings. Schulman adds that “T-Bill portfolios can yield approximately 0.75% to 1.5% more than money market accounts” and that income from them isn’t subject to taxes as CDs and money market funds are.
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