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Savings 101: What Is a CD (Certificate of Deposit)?

What Is a CD?

Banks and credit unions are known for checking and savings accounts, but it’s the certificates of deposit, or CDs, that can really help you increase your savings. CDs, or share certificates at credit unions, generally earn higher rates of return than regular savings accounts, as long as you don’t withdraw your money early.

Here are some facts about these savings certificates and how to decide whether one would fit your needs.

The basics

These common savings accounts are offered by many institutions. The key difference between regular savings and a CD is that withdrawing money from a CD before it matures can lead to penalties. That’s why they’re sometimes called “time deposits.”

CDs are typically offered in terms of three or six months, and one, two, three or five years. You can find them with terms as short as seven days or for 10 years, too. In exchange for locking away a consumer’s cash, CDs usually offer higher yields than a regular savings account. The rates typically increase with the length of deposit terms.

Deposits in bank CDs are backed by the Federal Deposit Insurance Corp. for up to $250,000 per depositor and ownership category, per insured bank. At federally chartered credit unions, certificates are insured up to the same amount through the National Credit Union Administration. Some state-chartered credit unions may operate with private insurance. All institutions with federal backing must display FDIC or NCUA signs at teller windows and on their websites.

Rates of return in the CD market can change every week. You can view the NerdWallet report for the most recent week to find the financial institutions with the best CD rates, as well as average rates by term and by location.

Types of CDs

Most commonly, CDs are offered with a fixed term and rate of return. However, some institutions offer variations, usually as promotional accounts, to attract new business.

Here are some common types:

Variable-rate CDs: These are sometimes linked to a market index or may let the depositor take advantage of future rate increases.

Low/no-penalty for early withdrawal: Also called liquid CDs. As a tradeoff for allowing greater access to your money, these certificates usually provide lower rates of return than traditional CDs and require you to maintain a minimum balance.

Callable CDs: Certificates that let the bank or credit union shorten the terms.

Jumbo CD: Essentially the same as a regular CD, but with a very high minimum balance (typically $100,000 or more) as a tradeoff for higher rates.

IRA CD: These are regular certificates that are held in a tax-advantaged individual retirement account, or IRA.

CD ladders

Many savers may want the higher rates of a three- to five-year certificate, but are wary of tying up their money for such long periods. CD ladders help to address this issue. The process is fairly simple: Invest proportionally in a variety of term lengths, then, as each shorter certificate matures, reinvest the proceedings in the longest-term CD.

For example, you take $10,000 and invest $2,000 each in a one-, two-, three-, four- and five-year CD.

At the end of the first year, when the shortest-term certificate matures, put the money into a new five-year CD. The next year, reinvest the funds from the maturing two-year certificate in another five-year CD.

Repeat the process until you have a five-year CD maturing each year. At that point, you’ll have the flexibility of cashing out one certificate a year without facing early-withdrawal penalties.

Fees and penalties

Most CDs carry a fee or penalty for early withdrawals, before the maturity date. You’d typically have to give up three to six months’ interest, depending on term of the certificate. Consumers should take note of the potential fee for a particular account before choosing to withdraw early. The loss of interest may outweigh the benefits of taking the money out immediately.

CD rates

Returns are typically quoted as an annual percentage yield, or APY, which includes the effects of the compounding period (the frequency with which a bank pays interest on the account). Banks can choose to compound rates on a yearly, quarterly, monthly or even daily basis.

A CD can be an important part of your overall savings plan. By choosing the right type, taking advantage of a laddering strategy and not withdrawing the funds until the certificate matures, you can earn a nice rate of return on your money with the security of having your savings backed by the federal government.

NerdWallet writer Margarette Burnette contributed to this article.

Updated Aug. 7, 2015.

Image via iStock.

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