A certificate of deposit (CD) account is a popular savings tool offered by banks and credit unions that require you to lock your money away for a set period of time in exchange for a fixed interest rate. It's important to understand how a CD account works, the different types of CDs available and the benefits they offer. A financial advisor can also help you incorporate CDs into your investment portfolio or financial plan.
What Is a CD Account and How Does It Work?
A CD, or certificate of deposit, is a type of savings account where you deposit a fixed amount of money for a set term, ranging from a few months to several years. In exchange for leaving your money untouched during that period, the bank or credit union offers a higher interest rate when compared with a standard savings account.
CD accounts are considered low-risk because they offer guaranteed returns and are insured by the FDIC (up to $250,000 per depositor per bank) or the NCUA for credit unions.
Once the term ends, or matures, you can withdraw your initial deposit along with the interest earned. However, withdrawing the money before the CD matures typically results in a penalty, which can reduce your interest earnings.
You should also note that CD rates fluctuate. Knowing this is important because rate changes can affect your potential earnings. Therefore, to mitigate risk, investors often buy fixed-rate CDs, as they guarantee the same interest rate for the entire term, regardless of market changes.
You could, however, make more money with variable-rate CDs if interest rates rise, as these CDs may offer higher returns that adjust with market conditions. But this also means taking on more risk, and potentially losing money when the market drops.
Common Types of CDs
Common types of CDs include traditional CDs, jumbo CDs, no-penalty CDs and bump-up CDs. Here's a closer look at each:
- Traditional CDs offer a fixed interest rate for a specific term. You deposit money, leave it untouched for the agreed-upon period and then withdraw your funds, along with interest, when the CD matures. Traditional CDs are ideal for individuals seeking predictable returns.
- Jumbo CDs require a larger initial deposit, typically starting at $100,000. In exchange, they often offer higher interest rates than traditional CDs.
- No-penalty CDs allow you to withdraw your funds early without facing penalties. While the interest rate on these CDs may be slightly lower than traditional options, they provide added flexibility in an emergency.
- Bump-up CDs allow you to increase your interest rate if market rates rise during your CD term. This feature can be beneficial if you expect interest rates to increase over time, but these CDs may offer slightly lower initial rates to compensate for the rate adjustment flexibility.
Benefits of CDs
If you're considering CD investments, here are five benefits to keep in mind:
- Higher interest rates: CDs are an attractive option for individuals looking to earn more on their savings without taking on significant risk.
- Guaranteed returns: Since CDs offer a fixed interest rate, you know exactly how much you'll earn over the term.
- FDIC and NCUA insurance: CDs are insured up to $250,000 per depositor, making them a very safe option. This guarantees that even if the bank or credit union fails, your money is protected.
- Predictable savings: CDs provide a clear timeline for when you can access your funds, making them ideal for individuals with specific savings goals, such as buying a house or funding a large purchase.
- Encourages discipline: By locking your money in a CD for a fixed term, you reduce the temptation to dip into your savings for impulsive purchases, helping you stay on track with long-term financial goals.
How to Open a CD
To open a CD account, start by researching different banks and credit unions to find the best rates and terms, and check that the institution is insured by the FDIC or NCUA.
Decide on the type of CD and the term that align with your financial goals, considering factors like interest rates, penalties and your ability to leave the money untouched for the duration.
If you can't access the funds without a penalty, make sure you're comfortable with the terms before committing.
Once you've chosen your CD, deposit the required initial amount using a bank transfer, check, or cash.
After funding the CD, your money will begin earning interest. Then, when the CD matures, you can either withdraw your funds or roll the balance into a new CD, as many banks offer automatic renewal options.
Bottom Line
A CD account can offer a secure and predictable way to grow your savings, with higher interest rates than traditional savings accounts. But you should also keep in mind that you could face penalties for early withdrawals. Additionally, since interest rates fluctuate, you could also miss out on higher interest rates if market rates rise during the CD term.
Financial Planning Tips
- Whether you're saving for a specific financial goal or simply want to build wealth, a financial advisor could help you determine which type of account or investment will fit your needs. Finding a financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.
- If you want to know how much your investment could grow over time, SmartAsset's investment calculator could help you get an estimate.
Photo credit: ©iStock.com/andresr, ©iStock.com/VioletaStoimenova, ©iStock.com/Jacob Wackerhausen
The post How Does a CD Account Work? appeared first on SmartReads by SmartAsset.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
