CDs work like other types of savings accounts but usually have higher interest rates and will penalize you for withdrawing money early. A certificate of deposit (CD) requires you to leave your money invested for a period ranging from a few months to several years in most cases. Financial institutions use a portion of the money deposited in CDs to issue loans and extend credit to their other customers, so they can pay relatively high yields on CD accounts.
Example of How a CD Works
A CD can help grow your savings. For example, if you invest $1,000 in a 3-year CD with a 5% APY, you could potentially earn a nearly 16% return on your investment. We’ll break things down in more detail below.
1. An investor deposits $1,000 into a 3-year CD with a 5% yield.
The minimum deposit requirement varies depending on the financial institution and the type of CD. The typical range is $500 to $1,000, but there are some CDs that do not have a minimum at all.
When you make your initial deposit, you can choose your desired maturity date. The bank will provide the interest rate and the annual percentage yield (APY). You can decide to have the interest disbursed to you at intervals, such as monthly, or receive it all at maturity.
The APY assumes you will keep your investment in the CD account for the entire term length. In this case, that is 3 years.
2. The financial institution adds a portion of the funds to its reserves and lends the rest to other consumers.
When the investor deposits $1,000 into the 3-year CD account, the financial institution retains a certain portion of the funds. The reserve acts as a safeguard for the bank to meet any immediate withdrawal requests from depositors. Once the reserve is set aside, the financial institution uses the remaining funds to provide loans and extend credit to other consumers.
3. The investor earns a total of $1,157 after 3 years.
If your $1,000 investment earns a simple 5% interest rate over a 3-year period, it would accrue $150. However, this $150 also earns interest. So, your total balance at the end of the 3-year period could be approximately $1,157, if the interest compounds annually. The financial institution determines how often the CD’s interest compounds. The more frequently, the higher the return.
4. Withdrawals before the 3-year period trigger penalties.
If you need to withdraw the funds from a CD before the maturity date, you may incur penalties. The penalties vary depending on the financial institution and the terms of the CD, but they typically involve forfeiting a portion of the interest earned or paying a fee.
A penalty for a 3-year CD could be 90 days of interest or a minimum of $25.
5. FDIC/NCUA insurance protects the investor’s money up to $250,000.
The Federal Deposit Insurance Corporation (FDIC) and the National Credit Union Administration (NCUA) provide insurance for each consumer’s investment at the same bank up to $250,000. So, if the financial institution fails, your money Is still safe.
Now that you know how CDs work, you may want to start shopping. You can compare CD rates here at WalletHub.
Are CDs a Safe Investment?
Certificates of Deposits (CDs) are generally considered a safe investment option. They are insured by the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Association (NCUA), up to $250,000. This insurance protects your principal investment, including any accrued interest, in case the bank or credit union fails.
Additionally, unlike riskier investments such as stocks, certificates of deposit ensure your principal investment always remains intact. While alternative options may offer higher potential returns, they also come with greater risks.
Are CDs a Safe Investment?
1. Research and choose a financial institution.
Start by researching different offers from banks, credit unions and other financial institutions. Consider factors such as interest rates, maturity dates, fees, and the financial institution’s reputation. Compare the options and select the CD that suits your needs.
2. Visit a bank or financial institution in person or online.
Some financial institutions require an in-person visit to open a bank account, but there are also plenty of online options.
3. Provide the necessary documents and fill out the application.
You will generally need to have this information:
- Social Security number (or Individual Taxpayer Identification Number)
- Valid ID, such as a driver’s license
- Date of birth
- Physical U.S. address
- Phone number
- Email address
4. Decide on the interest disbursement schedule.
Most financial institutions offer two options. You can receive all of the interest at the end of the term or at predetermined intervals, such as monthly or annually. If you want to maximize your earnings, it’s best to leave your money in the account until the CD matures, so you can benefit from compound interest.
5. Make your deposit.
Transfer the funds to the financial institution to open your CD. Minimum balance requirements vary by financial institution, but usually range from $500 to $1,000. Note, some do not have any minimums at all.
6. Confirm the details and store the documentation.
Once your CD is opened, the financial institution will provide you with confirmation of the account and any related documents. Keep these documents safe for future reference.
How Much Should You Invest in a CD?
There is no one-size-fits-all answer for how much you should invest in a CD. Your individual circumstances, financial goals, and risk tolerance should guide your decision. Consulting with a financial advisor can provide personalized guidance tailored to your specific needs and objectives.
Considerations To Determine How Much You Should Invest in a CD
Your Financial Goals
Start by assessing your financial objectives. Are you investing in a CD to save for a specific short-term goal, such as a vacation or a car? Or are you just looking to grow your savings over time? Understanding your goals will help you determine how much you should invest.
Your Risk Tolerance
CDs are low-risk investments with predictable returns. If you prefer a conservative investment approach, you might consider allocating a larger portion of your savings to CDs.
The Time Horizon
The term or duration of the CD is an essential aspect of deciding your investment amount. If you have a shorter time horizon, you may opt for a smaller investment. Conversely, if you have a longer-term outlook, you might consider investing a large amount of money.
Your Available Funds
Evaluate the amount of money you have available to invest. Financial experts generally recommend investing 15% of your pretax income. In order to diversify your portfolio, you should only invest a portion of that amount into CDs. Diversifying your investments across various assets can help manage risk and provide greater flexibility.
Balancing Liquidity Needs
If you will need quick access to your funds, keep your money in more liquid accounts, (i.e. savings or checking).
Types of CDs
- Traditional CDs: Traditional CDs offer a fixed interest rate for a specified term, typically ranging from a few months to several years.
- Jumbo CDs: Jumbo CDs are similar to traditional CDs but require a larger minimum deposit. They often offer higher interest rates compared to regular CDs.
- Callable CDs: Callable CDs give the issuer the option to redeem the CD before the maturity date. This means the issuing bank can choose to repay your initial deposit on the specified “call date.” Callable CDs typically offer relatively high interest rates, but if a CD is called, an investor’s returns may be reduced.
- Brokered CDs: Brokered CDs are CDs purchased through brokerage firms rather than directly from a bank. They offer access to a wider range of CDs from different banks, allowing for greater diversification.
- Step-Up CDs: Step-Up CDs have an interest rate that increases at predetermined intervals during the CD's term. This type of CD may have higher returns over time.
- Liquid CDs: Liquid CDs offer more flexibility and liquidity compared to traditional CDs. They allow investors to make partial withdrawals or close the CD before the maturity date, typically with some restrictions or penalties.
- No-Penalty CDs: No-penalty CDs allow investors to withdraw funds before maturity without incurring penalties. These CDs offer more liquidity than traditional CDs but may have slightly lower interest rates.
- Variable-Rate CDs: Variable-rate CDs have an interest rate that adjusts periodically based on changes in an underlying index, such as the prime rate or Treasury yields. The interest earned can fluctuate over the CD's term.
- IRA CDs: IRA CDs are certificates of deposit held within an Individual Retirement Account (IRA). There are no income taxes on withdrawals from an IRA CD if you’re in retirement.
Key CD Terminology
Minimum deposit requirement: Many financial institutions have minimum deposit requirements ranging from $500 to $1,000. However, some banks do not have any minimums.
Interest rate and annual percentage yield: During the term of the CD, your money earns interest, typically at a fixed rate. The annual percentage yield assumes your interest remains in the CD until maturity. A withdrawal will reduce your earnings.
Maturity date: Standard CD terms begin at three months and go up to five years, but there are some with terms as short as one month and as long as 10 years.
Early withdrawal: If you need to withdraw funds from a CD before its maturity date, you will likely face penalties. These penalties can vary depending on the terms and conditions set by the bank.
FDIC insurance: CDs offered by banks and other financial institutions that are members of the Federal Deposit Insurance Corporation (FDIC) are insured up to the maximum limit allowed by law, $250,000. This insurance provides protection in case the issuing bank fails.
NCUA insurance: CDs issued by credit unions are also insured up to $250,000. However, these deposits are protected by the National Credit Union Administration (NCUA), not the FDIC.
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