If you’re considering low risk savings vehicles, you’re probably asking “What is a certificate of deposit (CD)?” Certificates of deposit are sold at banks and offer a low-risk and typically low return. Your money grows slowly if you invest in CDs. Regardless of your investor profile, though, if you have money you want to keep relatively liquid for months to years, a certificate of deposit may be a savings solution for you.
Money kept in CDs over the investment term, also known as the duration or period, will earn interest at slightly higher rates than money left in checking, savings, or money market accounts. The interest earned is taxed as income by the IRS unless you purchase them in a tax-free Roth IRA or tax-deferred retirement account. If you’re investing in CDs, you’re probably in search of information about the most common types available at your bank.
What is a Certificate of Deposit? Types of CDs
All certificates of deposit are insured by the Federal Deposit Insurance Corporation (FDIC) up to USD 250,000, but not all CDs are the same:
- Traditional Certificate of Deposit: Your bank provides a fixed interest return on your deposited funds over a certain time period. When the CD matures, you can decide to withdraw the funds or roll them into a new certificate of deposit. The bank is likely to offer a slightly higher rate to lock your money up a little longer. If you might need some of the money before the maturity, you’ll pay a penalty for early withdrawal.
- Liquid Certificate of Deposit: This type of CD can help you to avoid paying early withdrawal penalties on CD savings. If you might need to access some of your money before the CD matures, a liquid CD may be a good choice. However, you probably won’t receive the bank’s highest CD rates with this type.
- Bump-Up Certificate of Deposit: If you’re concerned about rising interest rates, you’re not alone. A bump-up CD reduces your interest rate risk by allowing you to swap a current CD rate for a better one if rates rise during the investment term. Of course, if you’re invested in three-month CDs, you won’t be able to swap for higher rates on longer CD maturities. You may swap within the original maturity range selected.
- Zero Coupon Certificate of Deposit: A zero coupon CD can lower your reinvestment risk and this is an especially important consideration for your retirement funds. You won’t receive a payout of interest until the zero coupon CD matures. If the zero coupon CD isn’t invested in a retirement account, you’ll pay taxes on reinvested interest.
- Brokered Certificate of Deposit: If you’re a brokerage firm client, you probably know that your broker can offer CDs of literally thousands of banks around the country, including banks that transact business online. You may be offered higher rates from smaller banks or online/virtual banks because these institutions are competing for new deposits. In some cases, your broker-dealer may charge a fee to buy CDs. Ask about any associated fees before making a purchase.
- Callable Certificate of Deposit: If your bank offers a high introductory CD rate or interest rates are falling, your bank may tempt you to lock in money in a callable CD. However, the bank has the option to “call” your CD after a period of time. If this happens, the bank returns your funds plus interest. Broker-dealer firms typically offer callable CDs to attract new clients to small or virtual/online banks.
Now that you know a little more about certificates of deposit, you might want to know more about how to invest in a CD.
What is a Certificate of Deposit? How to invest in a CD
There are certain times that investing in a CD can make good financial sense. For instance, you’re planning to buy a home and want to keep your down payment funds safe and liquid. Before investing in a certificate of deposit, consider when you need the money and the interest rates offered by the bank:
- Time horizon: It’s important to know when you need some or all of your money before deciding to invest in a certificate of deposit. For instance, if you’re saving to purchase a home and don’t plan to start looking for a house for at least six months, a six-month CD can be a good choice if you have sufficient liquidity. Plan ahead for job loss or other emergencies with a separate emergency fund.
- Interest rates: Your perspective about interest rates is an important consideration. If you believe that interest rates are rising in the next six to 12 months, you might want to invest in a shorter-term certificate of deposit. If you believe that interest rates are falling or flat, a long-term CD investment can help you earn more interest over the term.
If you’re shopping for the best CD rates, you’ll see interest quoted in APR, the annual percentage rate the financial institution is offering, and APY, the annual percentage yield. APY is especially important if you’re investing in multi-year maturity CDs.
What is a Certificate of Deposit? Compounding
Capital invested in CDs benefits from compounding. Compounding is a way to describe your investment growth over a period of time. If you invest USD 10,000 for three years at five percent per year, the bank pays you USD 500 for year one. In year two, your account balance is USD 10,500, so your money earns USD 525. In year three, your money earns even more—about USD 551. You’ll take out USD 11,025 when your CD matures.
What is a Certificate of Deposit? Term, Type, and Interest Rates
Now that you know the answer to “What is a Certificate of Deposit?” your next steps include selecting the term, or how long you’re willing to invest, the type of CD, and the interest rates offered.
If interest rates are low and you’re looking to purchase a new car or home in the near future, buying a CD from your bank may make sense. Talk with your financial advisor about the best way to prepare for a significant purchase in that case.