What is a CD?
A CD, or certificate of deposit, is a savings account that has a fixed interest rate and fixed date of withdrawal, known as the maturity date. CDs also typically don’t have monthly fees. There isn’t much risk involved in opening one, as they are issued by banks and insured by the Federal Deposit Insurance Corporation, or FDIC, up to $250,000 per depositor. Share certificates, which are the credit union version of CDs, are also low risk, as they’re insured up to the same amount through the National Credit Union Administration.
A CD is different from a traditional savings account in several ways. Savings accounts let you deposit and withdraw funds relatively freely. But with a CD, you typically agree to leave your money in the bank for a set amount of time, called the term length, during which time you can’t access the funds without paying a penalty. 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.
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. Most CDs come with fixed rates, meaning annual percentage yields are locked in for the duration of the term. There are a few exceptions that we will explore below.
Why you might benefit from a CD or share certificate
CDs can pay off for folks who are certain they won’t need that cash during the term length. A five-year CD with a 2.50% APY will earn around $625 on a $5,000 deposit. Keep the same amount in a savings account that earns a top-of-class rate of 1.50%, and you’d earn around $375 after five years. In this scenario, a CD would earn you over 1.5 times what you would make with a high-yield savings account.
When to stick with a savings account
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 several months’ worth of interest accrued.
Take note of any such penalty on a CD before choosing to withdraw early. FDIC and NCUA insurance doesn’t cover penalties incurred by withdrawing money early. If there’s a chance you’ll need that cash to cover an emergency, skip the CD and stick with a high-yield savings account.
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.
- Bump-up CD: With these CDs, you can request a higher rate if your bank increases its APYs. These CDs typically have lower interest rates than fixed-rate CDs, and some carry steeper minimum deposit requirements. In most cases, you can request only one rate increase, although long-term CDs may let you do so twice.
- Step-up CD: This option provides more predictable rate increases, where APYs automatically go up at regular intervals. For example, rates on a 28-month step-up CD might go up every seven months.
- Low or 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.
- Jumbo CD: This is essentially the same as a regular CD but with a high minimum balance requirement — upward of $100,000 — as a tradeoff for higher rates.
- IRA CD: This is a regular certificate that is held in a tax-advantaged individual retirement account.
CD ladders provide flexibility
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 time. That’s where “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 a new long-term CD.
Say you have $10,000. With that cash you invest $2,000 apiece in one-, two-, three-, four- and five-year CDs. When the shortest-term certificate matures after one year, 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. 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.
CDs offer low risk, some reward
Investing in a certificate of deposit isn’t the quickest way to grow your money, but it’s not terribly risky, either. A CD with a good rate can play an important role in your overall savings plan.
By choosing the right type of CD, taking advantage of a laddering strategy and avoiding withdrawal penalties, you can earn a solid return on your money, all while having your savings backed by the federal government.
This article originally appeared on NerdWallet.com. By Tony Armstrong