Certificate of Deposit: What Is a CD?
A certificate of deposit, more commonly known by the abbreviation “CD”, is a type of savings account that offers a fixed interest rate and withdrawal date. These accounts typically provide an interest rate of up to 2.20% (this increases with your term) and have minimum deposit requirements.
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All CDs are insured by the federal government for up to $250,000 and they are offered by many lenders, including credit unions and both online and brick-and-mortar banks.
Traditional Savings vs Certificate of Deposit
Unlike a traditional savings account, which allows you to withdraw money several times a year, often without fees, a CD will incur penalties if withdrawn before the agreed-upon date. The money is still available before this date, and we’ll discuss how you can access it below, but for a CD to be a viable savings option, you need to leave it until the withdrawal date.
This has a positive effect on the interest rate, and CDs typically offer better rates than traditional savings accounts as they are more valuable to the bank. Banks and credit unions pay interest on savings because those savings help them to grow their collateral, which is then used to provide loans (at a much higher interest rate than they pay for savings) to other clients.
The more money they have in those savings account and the longer it stays there, the more freedom they have when it comes to offering high-interest loans.
Think of it this way: Imagine that a friend gives you $1,000 and says you can use the money to invest and turn a profit, but eventually you’ll have to repay them the full balance and a percentage of your profits. If they do this the “traditional” way, they can take back some or all of that money at any time, making your life very difficult and reducing your chances of profiting from their cash.
But if they agree to only withdraw after 5 years, you have more freedom, can make more money, and if they ever renege on their promise, the money you lose in interest will be covered by the fees they pay in penalties.
How Much are CD Early Withdrawal Penalties?
CD penalties vary from lender to lender and there is no fee cap, so it’s important to check the terms and conditions before you sign up. Generally, the fees are quoted in terms of how much interest you would have earned if the account had remained open for a specific time.
For example, you may see the words “6-month interest”, which means that on a balance of $5,000 with a 2% APY, the fee will be $99.50.
The higher the balance and the interest rate, the higher the fees will be. The term will also dictate how much you’re charged, as many 5-year CDs charge between 6- and 12-months’ interest.
If you withdraw early, not only are you missing out on interest you could have earned, but you’re walking away with less money than you deposited. To avoid these fees, you can try asking the lender for them to be waived or look into CDs that don’t charge such high withdrawal penalties.
Is a CD Worth It?
The best CDs offer between 1.5% and 2.2% in interest, which isn’t a great deal at all. If you invest $10,000 over 5 years with the highest of these rates, you’ll earn just over $1,040 in interest. It’s not a lot of money, especially when you compare it to the higher rates you can earn with stocks and bonds, but it does have its uses.
It’s important to see these accounts not as interest generators, but as cash protectors. That $10,000 will be placed out of reach, which means you won’t be tempted to spend it on things you don’t need.
Think about the last time you had a cash windfall, whether from a lottery win, an inheritance or a tax rebate. What do you have to show for it right now? If you’re like the average consumer, it was probably spent on vacations, clothes, nights out—it didn’t increase your net worth or make life easier for you and now it’s gone.
With a CD, that risk is negated. It’s like a virtual piggybank, only the day you reach for the hammer and crack it open, you’ll discover there are a few extra pennies inside.
As an investment tool, a CD is not great. But as a way of safeguarding your money against market fluctuations and your own spending habits, it’s perfect.
Ideal Length for a CD
A CD can last for months or years, it’s entirely up to you. It’s still classed as a short-term investment, however, because the limit is capped at 5-years, with the average range being between 3 months and 5 years.
The longer it remains in your account, the more you will earn. One of the misconceptions regarding these accounts is that you need to keep the money for at least a year to generate interest. However, while the rate you’re offered is an APY or “Annual Percentage Yield” it’s not actually calculated annually, and you can still earn money if you keep the CD for just 3 months.
A deposit of $5,000 kept for 3 months at an APY of 2% will earn $24.81 in interest. Nothing to write home about, but as discussed above, it’s not just about the interest.
The interest also compounds, which helps to build your balance further. For example, you will earn $100 in interest during your first year. But in the second year you’ll earn $202, because the interest is based on $5,100 and not $5,000.
If you keep that $5,000 for 5 years, you’ll earn $520.40 in interest, turning a $5,000 balance into $5,520.40.
There is no “ideal” range. It all depends on what you need the money for and why you’re investing. Many choose to invest in a CD after receiving a financial windfall and seeking to safeguard their future.
For example, let’s imagine that a grandparent dies and leaves you $60,000 in their will. You’re a student with several years of school remaining, so you put $10,000 in your bank account to cover expenses and use $20,000 to clear student loans.
The additional $30,000 can be placed in a CD until you finish school. That way, in four years, when it’s time to buy a car and start looking for work, you can withdraw your $30,000 along with the extra $2,472,96 in interest it will have accumulated (based on a 2% APY).