A Certificate of deposit (CD Account) is an agreement to deposit money for a fixed time period with a bank or financial institution that will pay you money. You can choose to invest your money for three months, six months, one year, or even five years. The longer your time commitment, the higher the interest rate. In exchange for the interest rate, you promise to leave your money and the interest with the bank for the entire time. When used correctly, CDs can be an important tool for financial management.
How Does a CD Account Work?
A CD account works by you lending the bank your money in return for interest. This is how a bank gets the cash it needs to make loans. The interest you get is less than the pay the bank gets from lending out the money so this is how the bank earns a profit. You still earn a higher interest rate than you would get for a checking account that gets interest since you can’t withdraw the funds for the time period agreed upon.
Those who get the most benefit are people that want some extra interest earned but won’t need access to the cash during the term. If you are looking for how to make money by just storing your money, there are some good options. Now we will explore the benefits and downsides of making a CD account.
Should You Make a CD Account?
There are different advantages to having a CD account. The first advantage is that your funds are safe. The Federal Deposit Insurance Corporation will insure a CD account for up to $250,000. This means that you never lose your principal. Since you don’t have the risk of losing your principal, these accounts are safer than stocks or bonds.
CD accounts also have higher interest rates than checking accounts or savings accounts. They offer higher interest rates than other safe investments, such as money market funds.
You are able to shop around for the best rate. Some banks give better rates since they need access to the funds. Online-only banks can usually give higher rates than a brick-and-mortar bank because costs are lower. When exploring the different options, you should also take a look at how the bank compounds interest. A CD that compounds interest daily will pay out more than one that does it quarterly.
There are many different types of CDs that you can explore. With a fixed-rate CD, your rate is locked for the length of your term. You can also choose a variable CD and the bank can raise or lower the interest rate based on other factors, such as interest rates in the market.
There are many CDs that have low or no fees. This way you don’t have to worry about fees that are impacting your earnings.
The main con of a CD account is that money is tied up for the life of the term. You will pay a penalty if you need to withdraw your money early.
You may be missing out on other investment opportunities while your money is tied up. For example, you can run the risk that interest rates may rise while your money is in the CD during the term.
Many CDs don’t pay enough in order to keep up with the rate of inflation. If you only invest with CDs then you will lose your standard of living over time. The best way to keep up with inflation is with stock investing but that is risky and it’s possible to lose your entire investment.
How to Choose a CD Account
You will need to take many different factors into account before you make a final decision on which CD is best for you.
You don’t want to withdraw money early since you will have a fee. This means you have to review your term and how long you are able to afford to invest your money. If you are saving for a short-term goal like a new car or a wedding then you may want to choose a shorter term. However, if you are looking for a low-risk way to build some long-term savings then choose a longer term CD.
Shop around to see who is offering you the best interest rates. Compare each annual percentage yield (APY). Know the current rates before you agree to any terms.
Pay Attention to Any Expected Rate Hikes
It’s good practice to keep an eye on the market and purchase CDs based on an expected rate hike. For example, if you think the Fed will raise interest rates by the end of the year then you want to get a short-term account and then cash out toward the end of the year. You can then open a long-term account with the higher rate.
Explore the Different Product Types
There are different types of CDs you want to consider. Some have adjustable rates or features that may be appealing to you depending on your financial situation.
If you want more flexible access to your money then you want to consider a CD ladder. This way, you'll have CDs that mature at different times and you may have money every few months that you can access.
Minimum Deposit Requirements
Some accounts may have minimum deposit requirements. This can range from zero to thousands of dollars. Some require high minimums and have good interest rates due to that while others require high minimums but don’t have the best interest rates.
Early Withdrawal Fees
While you may not plan to take out your money, you will want to know what your options are in the event of an emergency. You also want to know what the options are for withdrawing your money in order to get a better rate. If you are thinking about withdrawing your money early, calculate the withdrawal fee with the rate you would get from opening a new CD.
Confirm the Account Is Insured
Most CDs will be insured but you want to make sure it is insured so you always have protection in case your institution fails.
Avoid an Automatic Rollover
You have the option to just automatically renew the CD after the term ends but if you automatically renew it, you may not be getting the best rate. When your CD account matures, you need to go through the process of researching the best CDs and choosing one for your current financial situation.
Different Types of CD Accounts
When you are researching CDs, you will come across different options.
These are the most popular option because these CDs allow you to pull out your money before your maturity date. This allows you some flexibility if you need to pull your money out for an emergency or you find a better interest rate. Since flexibility defeats the purpose of a CD account, many banks will pay less on these types of CDs. Different banks will have different rules for how much you can withdraw and when you can. Banks can also limit the frequency that you remove funds from this CD. Some will allow only one penalty-free early withdrawal and others will want you to spread out your withdrawal.
If you don’t like the idea of locking up your money then a bump-up CD can be the right choice for you. These CDs will allow you to request a higher interest rate if rates rise. This means you can keep your money at the bank so the CDs should pay more than other liquids CDs. These types of CDs may only offer once increase per term so you will need to decide when the best time is to ask for a new rate. Some banks allow multiple increases on longer term CDs so you need to check to see what your bank allows.
These types of CDs will just automatically raise your interest rate at regular intervals. You will usually start with a relatively low rate but the rate will change over time. These are different than bump-up CDs since you don’t have to ask for the rate. The rate is also guaranteed at issue when it may not be guaranteed with a bump-up CD. These CDs aren’t actually all that common and current offerings aren’t all that competitive.
These CDs actually benefit banks. The main feature of these CDs is that the bank has the right to cash you out if it will make sense for them to cancel the CD. You would get the cash in your account but then you won’t be getting the interest rate. Since you risk having the CD called, you get paid more for your standard CDs.
These are just CDs offered by a financial intermediary. These CDs are brokered. This means a financial advisor or broker will survey the marketplace to find the best rate available. When you choose brokered CDs, you are given the option at a variety of locations, which can work to your advantage. The cost of these CDs comes out of your APY, which is the money you earn. It’s similar to a bank since the bank won’t usually charge you a fee to invest in a CD. However, the bank could pay you less or more depending on its own profitability concerns. This is the same for brokered CDs and your APY will depend on how much the intermediary wants to earn on the deal.
These CDs usually have high minimum balance requirements and will typically start at $100,000. It can be a safer place to stash money because it is FDIC insured and you can earn a good interest rate.
What to Do When Your CD Matures
When a CD matures, you are then able to take the money out of the account without paying any penalties. The maturity date can usually be a part of the CD name. For example, if you have a six-month CD then your CD account matures six months after you deposit the money into your account. You may also see the maturity date on your paperwork. If you aren’t certain, be sure to ask your bank.
Before your CD matures, you will get a notice from your credit union or bank. On the notice will be the maturity date, the default action that will happen if you do nothing, the new rate if you want to renew your CD, the maturity date if you renew your CD, and the deadline to request action, whether it’s taking out the money or renewing.
If you do nothing after you get your notice then the bank usually puts your money into another CD account with the same length of the CD that just matured. However, the interest rate likely won’t be the same. Banks will pay what they currently offer so it may be less or more than what you could be currently getting. Some banks will use a lower renewal rate to take advantage of those who may be too busy to do anything.
The most important thing to remember once your CD matures is that you have options. You can renew, you can choose a different CD, or you can move the money to a different bank or your savings or checking account.
Avoiding Your CD Penalties
One of the disadvantages of a CD could be a penalty but there are ways to avoid them. The reason behind penalties is the bank wants you to keep your money invested for a set period. The bank will benefit from having the certainty of knowing how long it can use your money. Since a bank uses your money to lend to other customers or get investments, if you demand your money early then the bank may have to pay its own penalty somewhere down the line.
When you have a penalty, you can actually lose money and then walk away with less than you deposited. Not to mention, you can miss out on interest you would have earned.
How to Avoid Penalties
If you must cash out early, it’s best to look for ways to dodge any penalties. It never hurts to ask. It’s possible that the staff can waive the penalty if it’s an emergency and you are at a smaller credit union or another friendly institution. You want to make a request in person or over the phone. Using an automated system won’t work for you.
The other options you have to avoid penalties are using more flexible ways of sorting your money. Laddering CDs can be a strategy where you have more than one CD so they mature more often and you have the opportunity to have the money penalty-free at that time. Money market accounts may not give you as much as CDs but you have limited spending so you have some access to your money. Credit cards can be an expensive way to borrow but if you need your money quickly and you have a CD that is about to mature, you can use this strategy. Put the emergency expenses on the card and pay it off as soon as the CD matures.
Using a CD Ladder
How a CD Ladder Works
A CD ladder is a strategy to use so you can avoid early withdrawal penalties but still have access to money at regular intervals. For example, if you have $10,000 to invest then you put a quarter in a one-year CD, a quarter in a two year CD, and so forth.
Once one CD matures, you then cycle the mature funds back to the end of the ladder, beginning with the one-year CD maturity. You can make this more complicated by adding six-month intervals or longer term CDs but the more complicated you make it, the more time you have to put into account management. Things can fall apart if you aren’t staying on top of it.
Length of a CD Ladder
Determining how long your ladder should be will depend on what you want to accomplish. Those with longer maturities likely pay higher interest rates since you are taking on more of a risk. A longer ladder will mean that you should earn more. You may earn less if rates go up quickly after you set up the ladder when interest rates are still low. Many people will stop at three to five years. You do need to be comfortable locking up your money for a while if you are going to do a CD ladder.
You will typically be stuck with the interest rate that is available when you start to invest your money. This will work in your favor if the rates are high but if you see rates go up after you locked in a rate then this can be upsetting. If you are able to predict that rates could rise then you want to wait before you build your ladder or keep maturities on the shorter end. If you know that rates are going to fall then choose a ladder that skews toward longer maturities.
A CD ladder is a long-term project and if you have early withdrawal penalties, this can wipe out your earrings if you need to cash out. If you think you may need to cash out early, you may use other alternatives that are more liquid and allow for penalty-free withdrawals.
CD Accounts Versus Other Financial Investments
Money Market Investments
Many people will compare CD accounts to money market investments. There are two different types of money market investments: funds and accounts. Money market accounts are FDIC-insured savings products offered by a bank. These accounts usually pay higher rates than a regular savings account but will have restricted withdrawal rights. Money market funds are not insured by the FDIC and hold investments such as Treasury bills and CDs.
With a CD account, you are able to calculate your expected earnings before you invest since you know your tax bracket and your interest rate. This isn’t possible with a money market account or fund because the interest rate can change over time. The interest rate will be directly proportional to the investor's level of deposited assets and not to the maturity. Money markets are then more beneficial to wealthier investors. CDs are a better solution for individuals who want to focus on capital preservation instead of growth.
If you want to access your money at any time then a savings account may be a better option for you. CDs provide a guaranteed interest rate that typically won’t change. If you think interest rates will rise soon then a savings account can make sense while you wait. However, if you are happy with the interest rates and are willing to lock up the money then a CD does work well. CDs will reward you for your investment with higher interest rates.
However, savings accounts help you keep your options open. A savings account is a good place for an emergency fund or a cash cushion that you can access at any time. There are usually no minimums so they work well if you have limited funds to start. You usually don’t have to choose between savings accounts and CDs. You can use both to meet your needs. Keep some cash in a savings account to meet any short-term needs. Consider using a CD account for any of your excess cash if you have enough cash in savings.
Are There Taxes on CD Accounts?
You may be wondering if there are taxes on your CD account and, if so, if there is a way to avoid paying the taxes so you can keep your money in your account.
In taxable accounts like a joint or individual account, you will usually pay income tax on the interest you earn from a CD. The IRS treats any interest you earn as interest income and you report the income. When your CD matures and you transfer it to your checking account or savings account, this will usually be a return on your principal, which is not taxable.
However, taxes on a CD account aren't always straightforward. Speaking with a tax advisor can help.
You should receive a 1099-INT form if you get more than $10 in interest. Even if you make less in interest, you should still report the income to the IRS. There isn’t a specific tax rate for any interest you earn on a CD account. The rate you pay for taxes will depend on everything else you have on your return. Your tax rate changes from year to year.
If you pulled out your money early and have a penalty then look in Box 2 of your 1099-INT. In certain cases, the penalty could be deductible.
Strategies for Users
There are some strategies you can to use to make sure you are making the most of your CD account.
Develop a Strategy
Start by figuring out when you are going to need your money, in order to help come up with a strategy. It’s not wise to store all your money in a CD account if you want to avoid penalties. A one-year account can be a good decision if you are going to buy a house in a few years since you are protecting your money but still earning some interest. You don’t want to take a risk by investing it but you still want to earn some money on your investment.
Research Multiple Options
Money that is meant for an emergency should be divided between a CD and a savings account. This will help you ensure you have funds for any immediate transactions due to an emergency. You still need some money that is liquid for emergencies. You will want to shop around since it can be hard to find a good deal without doing some research first. See what your existing bank is offering first since that is the easiest, then begin researching your other options.
Online banks may pay higher rates than others. Consider other promotions or bonus rates. The local credit union may want to you to park your money there so they could offer a bonus. It helps to know how the CD compounds work. Compounding is when the interest is paid on the principal as well as the interest that has already been paid. The more often the CD compounds, the better. The best option is to find one that compounds daily. Compounding daily is common but there are some banks that only do it monthly or quarterly.
A CD account can be an important financial tool in order to boost some of your savings. There are different advantages to it, including that it is safe and will allow you to earn more money than you would with other safe investments. However, your money will be tied up for a certain time period unless you pay early withdrawal fees. There are different types of CDs and it’s important that you shop around for the right one for your needs. Some online banks can offer higher interest rates that you may want to take advantage of. There are different strategies you can use to boost your CD account savings, including CD laddering.