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Banking 101: What Is a CD and How Does It Work?


Written by Lindsay VanSomeren | Published on 5/28/2019

Note: This article is part of our Basic Banking series, designed to provide new savers with the key skills to save smarter.

Sometimes it seems like savings accounts only grow at a snail’s pace. Even if you have a decent sum of money saved, it can take a while to earn anything meaningful.

This is where certificates of deposit — commonly abbreviated as CDs — can come into play. These timed deposits allow you to grow your savings even further. They’re generally insured by the Federal Deposit Insurance Corp. or National Credit Union Administration up to $250,000.

Still, CDs aren’t right for everyone or for every case. So what is a CD? We’ll discuss what you need to know about CDs so you can get a full understanding of how they work.

In this article we will cover:

What is a CD?

A CD is known as a timed deposit because you typically cannot deposit or withdraw money during a certain period. Term lengths vary by financial institution, although they commonly range from a few months to five years. Interest rates — which are usually fixed — are often higher with longer terms.

CDs generally require a deposit of at least $500, though there are online banks that’ll offer CDs with no minimum deposit. You may also be charged a monthly or annual maintenance fee, though it’s not standard.

Once the CD’s term is over, it matures and becomes available for you to withdraw, along with the interest. You only get a short grace period to withdraw the money, however, before it will roll over into another CD of the same (or similar) type.

CDs — commonly referred to as share certificates at credit unions — are generally the highest-earning deposit accounts available at banks and credit unions. If you choose a CD at a bank or credit union, it should be FDIC-insured (at banks) or NCUA-insured (at credit unions) up to $250,000.

The biggest disadvantage of CDs, aside from possibly needing larger deposits, is that you’ll typically pay steep early withdrawal penalties to pull your money early. These fees, which will be a certain amount of interest that you’ve earned or would have earned on the CD, typically depend on your CD’s term length. For example, if you withdraw your money early from one of Ally Bank’s 24-month CDs, you’ll have to pay 60 days’ worth of interest on the amount of money you withdraw.

Should I choose a CD or a savings account?

CDs aren’t inherently better than savings accounts, and vice versa. Rather, you can look at these accounts as two different tools to reach your goals, depending on what those are.

“If you have savings and a goal for those savings sometime in the future, a CD can be useful,” said Ken Tumin, founder and editor of DepositAccounts. “The lack of access won’t be an issue if you are waiting for a specific time in the future to use the money. The lack of access can also be beneficial if it deters you from spending the money on things not related to your goal.”

For example, if you have money saved and want to use it to buy a new car for your child when they turn 16 in five years, a CD might be a good choice to maximize your earnings in that time. That’s especially true if you might be tempted to spend that money early, since a CD will lock that money away for the future.

On the flip side, Tumin said savings accounts are better suited for things like emergency funds and short-term savings goals where you might need to deposit and withdraw money anytime. That way, even though you’ll be earning less interest, you can avoid costly penalties.

If you have a specific savings goal in mind, it’s also a good idea to run the numbers to see how much you’d earn with either account type, and whether those earnings would offset any penalties and hassles of using a CD instead of a savings account.

“For example, if you have $1,000 and you have a one-year time frame, you can earn $20 in an online savings account that has a 2% yield,” Tumin said. “Using a 1-year CD that offers 3% APY would earn $30 of interest. The extra $10 may not be worth the reduced accessibility and the extra work opening and managing a CD.”

Different types of CDs

Just like how CDs are different from any other kind of deposit account, so, too, are the types of CDs. Here are some of the most common ones you might run across:

No-penalty CD

Step-up CD

Bump-up CD

Jumbo CD

IRA CD

No-penalty CD

A no-penalty CD allows you to withdraw your money anytime without paying any fees. In return, however, you’ll typically earn a slightly lower interest rate than on a normal CD.

Step-up CD

A step-up CD is a type of variable-rate CD in which your interest rate will rise according to a schedule at predetermined rates and times. These types of CDs usually offer a blended rate that gives you the average of your rates over time so that you can compare them to regular CDs.

Bump-up CD

A bump-up CD is similar to a step-up CD in that your interest rate can increase over time. However, you get to choose when this interest rate rise happens, rather than it happening automatically according to a schedule. Choose wisely since you can usually do so just once per term.

Jumbo CD

If you have a very large deposit (usually $100,000 or more), you can use a jumbo CD. These often offer higher interest rates than on normal CDs. However, keep in mind that FDIC and NCUA insurance generally only covers you up to $250,000 per bank or credit union.

IRA CD

An IRA CD is one that you open within the framework of an individual retirement account. This allows you certain tax advantages while saving for retirement.

What is a CD ladder?

The highest interest rates on CDs are generally given to the longest-term CDs. This poses a conundrum: How do you earn the highest interest rates while still having regular access to your money in case you want to withdraw it? A CD ladder offers a convenient solution to this problem.

With a CD ladder, you divide your money among a staggered set of long-term CDs. To start, for example, you may deposit $1,000 each in a 1-year, 2-year, 3-year, 4-year and 5-year CD. As each CD matures, you roll the old CD into a new 5-year CD. By the end of five years, all your money will be held in high-interest 5-year CDs, with a fifth of your money becoming available every year if you want to withdraw it.

“It’s most appropriate for long-term savings goals or for a part of one’s investment portfolio,” Tumin said. “Most people depend on stock and bond mutual funds for their long-term investing. If you want to add CDs as part of your portfolio, it makes sense to use CD ladders. Laddering provides regular access to the CDs, and they allow you to invest in CDs without having to worry about the direction of interest rates.”

Bottom line

CDs aren’t right for everyone and every situation. But if you don’t mind locking away your money for a bit and still want to earn the highest interest rates possible at a bank or credit union, a CD is definitely the way to go.

Just make sure you fully understand the terms of the CD and — more importantly — remember to mark the maturity date on your calendar to use your money (plus interest) once it becomes available.

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