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What Is a CD (Certificate of Deposit)?

February 29, 2016 Banking, CDs
What Is a CD?

Checking and savings accounts are the bedrocks of our financial lives, the ones we use practically every day to spend and manage our money. But neither does much to make that money grow. You might then be looking around at your bank or credit union for an alternative.

That’s where certificates of deposit come into play. CDs (or share certificates, as they’re called at credit unions) are a way to enjoy higher returns on your money without a lot of risk.

But before committing to a CD — and “commit” is the operative word, as you’ll see — you should know how they work and determine whether one will fit your needs.

The basics

CDs are different from traditional savings accounts in several ways, but mainly in that a CD is what’s called a timed deposit. Whereas with a savings account you can deposit and withdraw funds relatively freely, with a CD you agree to keep your money there for a set period of time, called the “term length.” Term lengths can be as short as a few days or as long as a decade, but the standard range of options is between three months and five years.

Generally speaking, the longer the term length — the longer you commit to keeping your money in the account and thus with the bank — the higher the interest rate you’ll earn.

Rates

As a reward for parking your cash with them for a longer time, banks and credit unions often offer higher returns on CDs than they do on standard savings accounts. Rates are quoted as an annual percentage yield, or APY, which considers the frequency with which interest is paid on the account (aka the “compounding period”). Banks can choose to compound rates on a yearly, quarterly, monthly or even daily basis.

The average rate on a three-year CD taken out at a bank currently stands at 0.49%. However, many credit unions and online-only banks offer certificates with rates above 1%.

Rates of return in the CD market can change by the week. To find the highest rates currently offered by banks and credit unions, check out NerdWallet’s best CD rates tool.

» MORE: What the Fed rate increase means for your CDs

Penalties

If you end your commitment early by withdrawing the money before the CD matures, you’ll likely be charged a penalty. It varies, but typically you’ll give up three to six months’ worth of interest accrued. Consumers should take note of any such penalty on a CD before choosing to withdraw early. The loss of interest may outweigh the benefits of taking the money out.

Insurance

CDs at most banks are backed by the Federal Deposit Insurance Corporation, or FDIC, for up to $250,000. At federally chartered credit unions, share certificates are insured up to the same amount through the National Credit Union Administration, or NCUA. Some state-chartered credit unions may operate with private insurance. This insurance does not cover penalties incurred by withdrawing funds early.

How can you tell if your bank or credit union offers insurance? All institutions with federal backing must display FDIC or NCUA signs at teller windows and on their websites. If they do, coverage is automatic. You don’t have to apply for your money to be insured.

Types of CDs

CDs typically come with a fixed term and a fixed rate of return. But depending on where you bank, you may have access to a few other varieties.

  • Variable-rate CD: This is tied to the prime interest rate, Treasury bills, a market index or some other driver — it varies by institution — and lets the depositor benefit from potential future rate increases (or the opposite).
  • Low/no-penalty for early withdrawal: In exchange for allowing you greater access to your money, these certificates (also called “liquid CDs”) usually provide lower rates of return than traditional CDs and require you to maintain a minimum balance.
  • Callable CD: This might come with a higher interest rate than a regular CD, but the bank retains an option to unilaterally shorten the terms — to in effect say at any point, We’re not getting so good a deal anymore, so let’s end this. Before you get drawn in by the higher rate, read the fine print to see if the CD is callable.
  • Jumbo CD: Essentially the same as a regular CD, but with a very high minimum balance requirement (upward of $100,000) as a trade-off for higher rates.
  • IRA CD: These are regular certificates that are held in a tax-advantaged individual retirement account, or IRA.

CD ladders

Some savers might want the higher rates of a three- to five-year certificate, but are wary of tying up their money for such a long period of time. That’s where the practice of “laddering” can come in handy. You invest proportionally in a variety of term lengths. Then, as each shorter certificate matures, you reinvest the proceeds in the CD with the longest term.

Let’s look at an example. Say you have $10,000. With that cash you invest $2,000 apiece in one-, two-, three-, four- and five-year CDs.

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

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

The bottom line

Investing in a certificate of deposit is not the quickest way to grow your money, but neither is it terribly risky. Indeed, a CD can play an important role in your overall savings plan.

By choosing the right type of CD, taking advantage of a laddering strategy and not incurring withdrawal penalties, you can earn a solid return on your money. Better yet, you’ll benefit from the security of having your savings backed by the federal government.

Tony Armstrong is a staff writer at NerdWallet, a personal finance website. Email: tony@nerdwallet.com. Twitter: @tonystrongarm. NerdWallet writer Margarette Burnette contributed to this article.

This article has been updated.

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