How Do Certificates of Deposit (CDs) Work?

How Does a Certificate of Deposit Work?

While the compact disc has aged poorly, the bank version of the CD — the certificate of deposit — retains a certain popularity for risk-averse savers. Both credit unions and banks offer certificates of deposit, and they are FDIC insured up to the $250,000 limit. However, you may be wondering, “Exactly how do CDs work?” It’s simple: you deposit a set amount of money for a specified period of time and earn a fixed or variable annual percentage yield. CDs are best for consumers with a comfortable amount of liquid assets because funds cannot be withdrawn early without facing a penalty.

How Do CDs Work for Investing?

Investing in a CD should start with a search for the best rates possible. Different financial institutions can offer drastically different rates. By finding a higher fixed APY, you increase your earnings for the life of the CD. Online banks often provide higher returns, so always research web-based options in addition to hometown financial institutions.

Rates may also vary based on the term of the CD. 3-month, 6-month, 1-year, 18-month or multi-year terms are common CD options. For example, as of December 2019, Synchrony Bank offers a 0.75% APY on a 3-month, $2,000 CD. The return on the same deposit climbs to a 2% APY with a 12-month investment or a 2.25% APY with a 60-month CD.

According to Discover, the three key factors in determining CD rates are the length of time until maturity, current interest rates and the expected rate of return for the bank. A key component banks use in determining interest rates is the short-term federal funds rate set by the Federal Reserve. When it goes lower, lower yields for CDs typically follow and vice versa.

After you find a CD with a good return and an investment period you can accept, such as 12 months, you open the CD account and deposit the minimum amount of money required or more. Some banks also offer a tier of interest rates, meaning that if you deposit all of your money in one CD, you may earn access to a higher APY than splitting your funds across multiple CDs or savings options. For example, the 11-month Ally No Penalty CD starts with a 1.65% APY with a deposit of less than $5,000. Over $5,000 provides a 1.70% return. A $25,000 or above deposit earns 1.90% as of December 2019.

As your CD earns interest, it is generally credited to your account on a monthly basis. When the CD reaches maturity, you can access your funds without paying a penalty. If you do withdraw money early, penalties typically take the form of striking your earned interest for a set period of time, such as 60 days of interest or more. However, some banks may charge a flat fee.

When your CD reaches maturity, you only have a brief window of time, such as two weeks or 10 business days, to access your funds before a default action is taken by the issuing bank. This can include rolling your funds over into another CD for the same length of time, so make sure you review your maturity notice and pick the best choice for your next investment.

How Variable-rate CDs Work

A variable-rate CD can provide you with access to higher returns for your savings than traditional savings accounts while helping you avoid being locked in at a low APY should rates increase over the life of your CD. The downside is that interest rates can also decline, limiting your earnings compared to a fixed-rate option. This makes researching a variable-rate CD best when rates are low. Also important to consider is how often your bank adjusts rates. Without frequent tweaks, you could miss out on months of improved earnings.

An additional variable option is a CD with access to a “bump-up” rate. These provide an opportunity for you to adjust the CDs rate before maturity. This could be an advantage if interest rates climb. However, you should think twice if you are accepting a lower initial APY to access the bump option and the term of the CD. If your bump may only provide access to a few months of improved APY, you may be sacrificing higher overall returns if you accept a reduced starting rate.

How Jumbo CDs Work

Jumbo CDs require larger minimum balances than regular CDs. They typically provide an enhanced APY to attract savers, but it isn’t always higher than a regular CD. Traditionally, a jumbo CD may require an investment of $100,000 or more, but some products with minimum deposits of $25,000 or above are also considered jumbo.

How CD Ladders Work

Savers who want to maximize returns and ensure access to the best interest rate possible with a portion of overall savings often use a CD ladder strategy. For the purposes of our explanation, we will use term increments of one year, but the same strategy can be used with 3-month, 6-month or any other CD term.

To start the ladder, you divide the amount of money you plan to invest in CDs by a set amount, such as five. You then invest in five different CDs — a 1-year, 2-year, 3-year, 4-year and 5-year option. As each CD matures, it is then re-invested in a 5-year CD unless you have plans to invest or use the funds elsewhere. This provides access to a portion of your savings on an annual basis and the opportunity to invest at different rates. In the best-case scenario, you experience an overall higher rate of return because you are investing in more long-term CDs over time.

When you prefer to retain easier access to your principal, a 12-month ladder strategy with 3-month, 6-month, 9-month and 12-month CDs will provide the opportunity to cash out funds every three months. A short-term ladder strategy is great for savers with fewer liquid assets while a mega-saver may experience maximum yields with a longer-term ladder.

The Final Word

Certificates of deposit are a safe way for savers to access improved earnings while still retaining the ability to access cash in an emergency. Flexible terms as low as three months make a CD accessible to a large range of consumers, but in a period of low interest rates, the APY on low-deposit short-term CDs may not compete with the APY on a higher-yield savings account. However, the use of specific strategies, such as a CD ladder, can help improve returns over time as savings increase.