What Is a Certificate of Deposit (CD) and How Does It Work?

“Save early and often” is common financial advice and it provides a pretty solid baseline for a healthy financial future. However, saving with a specific strategy—including a plan to earn on those savings—can be especially beneficial. If you don’t want to just save passively and are looking to get a high return on your savings, a certificate of deposit is worth considering.


A certificate of deposit (CD) is a type of savings account with a fixed interest rate and fixed time period. CDs typically have higher interest rates than other savings accounts—meaning you can get more out of what you put in—but they often require you to lock money in for a set period of time (often between three months and five years) and have an early withdrawal penalty. Depending on your individual goals and needs, CDs can be a great way to optimize your savings, or you may be better off opting for another option.


Keep reading to learn more about CDs, what they look like in the current financial climate, and how to know if they’re the right choice for you.





The benefits of CDs right now

Federal Reserve officials have raised the federal funds rate several times this year, and while that can increase the cost to borrow funds, it can also produce a higher yield when you save. “Returns on CDs are moving in the right direction for savers, with the Federal Reserve boosting interest rates aggressively in an effort to bring inflation down,” Greg McBride, chief financial analyst with Bankrate.com says. “The outlook for the next 12 months—higher returns and hopefully tamer inflation—is considerably better than what CD investors have endured over the past three years when interest rates fell to record lows and then inflation soared to 40-year highs.”


According to Nerdwallet, CD rates are currently some of the highest that they have been in a decade, making right now an optimal time to open one.


CDs also become more attractive during times of uncertainty because they are viewed as a much safer form of investment compared to stocks and bonds where you might lose a portion of your principal. This is because CDs are insured by the FDIC up to the $250,000 legal limit, meaning that even if your bank goes under, you’ll still get your money back.



The cons of CDs

The term of CDs can vary from 30 days to five years, and for that time period, your funds are essentially in a lock box—of which you don’t have the key. “It is important that an investor understands that once they invest in a CD, those funds are tied up until maturity,” cautions Darleen Gillespie, chief retail banking officer at First Bank. “In cases where someone must access those funds [before the term ends], they run the risk of incurring a penalty to withdraw. This can erode any interest they may have earned. In some cases, a bank can also dip into the original amount you put in, if needed, to cover a penalty.


Before you lock up your money in a CD, be sure you understand the fixed terms, penalties for breaking CDs, and other fees associated with an early withdrawal.


It’s also important not to put all your eggs in one basket, savings-wise. Since the funds in your CD typically aren’t accessible without penalty, it’s important to have an emergency fund or other account that you can pull from in the case of an unexpected job loss, sudden medical bill, or other large expense.



Types of CDs

James Morgan, vice president of savings and forecasting at Consumer Bank at Capital One, says you can choose different CDs for different strategies and purposes. One option, he explains, is a no-penalty CD, or liquid CD, which allows you to take out your cash before the term is up without an early withdrawal penalty.


For instance, Morgan says if you put $5,000 in a three-year liquid CD, but you need $1,000 after a year, you may be able to take that amount out of it without a penalty. “Some liquid CDs have limits on how much you can take out without a penalty,” continues Morgan. The downside, though, is “they may also offer lower rates than other CDs that don’t offer the option to access your funds early,” he adds.


Other CD options include a high-yield CD, which has higher-than-average rates, a jumbo CD, which has a high minimum deposit (typically at least $100,000) in exchange for a higher interest rate, an IRA CD, which is held in a tax-advantaged individual retirement account, and more.


So, before deciding what term to get, examine all of the available options and think through your savings goals so you can choose the right CD for you.

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