What is a Certificate of Deposit?

I’m looking for a long-term savings option and I’m considering a Certificate of Deposit. What do I need to know about CDs before I decide to open one?

Q: I’m looking for a long-term savings option and I’m considering a Certificate of Deposit.

What do I need to know about CDs before I decide to open one?

A: When it comes to saving money, most people automatically think of traditional savings accounts. But, what if you could earn higher interest while still keeping your money safe? That’s where Certificates of Deposit (CDs) come in. CDs, also known as share certificates of deposit, are a low-risk, high-reward option for those looking to grow their savings without taking on the risks associated with investing in stocks or other volatile assets.

Let’s take a closer look at CDs and why they might be a better choice for you over keeping your funds in a savings account.

What is a Certificate of Deposit?

A Certificate of Deposit is a time deposit account offered by financial institutions that locks  in that money for a fixed time period in exchange for a guaranteed interest rate. Unlike a traditional savings account, where the consumer can withdraw money anytime, a CD requires the owner to leave their funds untouched for a set term, typically ranging from a few months to several years.

Once the term ends (known as the maturity date), you get your initial deposit back along with the interest you’ve earned.

Why choose a CD over a savings account?

Both CDs and savings accounts allow you to earn interest on your money, but there are important distinctions between the two products. Here are some key reasons you might choose a CD over a traditional savings account:

• Higher interest rates. CDs typically offer better returns than regular savings accounts, helping your money grow faster.
• Predictable growth. The interest rate on a CD is typically locked in for the entire term. This enables you to accurately predict its growth.
• No temptation to spend. With your money locked in, and thus not easily accessible, you won’t be tempted to dip into your savings for impulse purchases.

Why are CDs considered a safer investment?

CDs are one of the safest investment options available to the savvy saver. Here’s why.

• Insurance. CDs issued by banks are insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000 per depositor per bank, and CDs issued by credit unions are insured by the National Credit Union Administration (NCUA) for the same amount. This means that, even if the bank or credit union fails, your money is protected.
• No market risk. Unlike stocks or mutual funds, CDs are not subject to market fluctuations. Your principal is guaranteed, and your returns are fixed, regardless of what is happening within the stock market at the time.

Why do CDs offer a larger return?

Financial institutions can offer better returns on CDs because they know they can use your money for longer periods. Banks and credit unions will use your deposited funds to issue loans or make investments, allowing them to offer higher interest in return. On a similar note, a CD with a longer term will feature a higher interest rate than a shorter-term CD.

Why does my money have to be locked in with a CD?

CDs provide financial institutions with a stable source of funds that they can use for lending or investing. In exchange for locking in your money, they offer a higher return. This fixed commitment period is what allows them to guarantee a higher interest rate than on a regular savings account. If CDs did not feature this restriction, and instead allowed frequent withdrawals, financial institutions would not be able to plan their lending strategies effectively or offer attractive returns.

Why are there penalties for early withdrawals?

Banks and credit unions impose early withdrawal penalties to discourage people from breaking their commitment by withdrawing funds before maturity. These penalties serve two purposes:

1. They help financial institutions manage their funds effectively. Since banks and credit unions use CD deposits for loans and investments, unexpected withdrawals can disrupt their financial planning.
2. They encourage disciplined saving. The penalty ensures that people only invest money in a CD if they’re truly committed to leaving it untouched.

Early withdrawal penalties typically vary based on the term length, but they often range from a few months’ worth of interest to losing a portion of the principal in some cases.

Factors to consider before opening a CD

Before you commit to a CD, here are a few important factors to keep in mind:

• Interest rates. It’s important to compare rates from different banks and credit unions to ensure you’re getting the best return.
• Term length. Choose a term that aligns with your financial goals. If you think you may need access to the money in the near future, opt for a shorter-term CD.
• Early withdrawal penalties. Understand the penalty structure in case you need to access your money before the maturity date.
• CD laddering strategy. If you want to maximize returns while maintaining flexibility, consider a CD laddering strategy, which involves investing in multiple CDs with staggered maturity dates to access funds at regular intervals.
• Inflation risk. If inflation rises faster than your CD’s interest rate, your purchasing power may decrease. Consider this before locking in a long-term CD at a lower rate.

Is a CD right for you? 

A CD can be the right choice for individuals who are looking for a safe and predictable way to grow their savings. It can be ideal for:

• People who don’t need immediate access to their money.
• Individuals who want a higher interest rate than a savings account offers.
• Investors looking for a risk-free place to store funds.

If you need liquidity and easy access to your money, a savings account or a money market account may be a better fit.

If you think a Certificate of Deposit may be the right choice for you, visit our savings rate page for more details.