![What is a CD? How a certificate of deposit can help you earn more over time (1) What is a CD? How a certificate of deposit can help you earn more over time (1)](https://i0.wp.com/cdn.businessinsider.nl/wp-content/uploads/2021/07/6102c844aedf2100190eedaf.jpg)
- A certificate of deposit (CD) is a type of deposit account that offers a fixed interest rate.
- To earn that rate, you'll need to keep your funds in the account for a certain period of time.
- But if you withdraw funds before the end of the CD's term, you'll have to pay an early-withdrawal penalty.
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If you've got some extra cash and you're wondering where to park it, you've probably looked at savings accounts. You might have even thought about investing it if you're trying to make the most of your money. If that's the case, you might want to consider a certificate of deposit (CD).
With a CD, you can earn a little more without the risk that comes with putting your hard-earned savings into the stock market. That being said, there are some terms you should be aware of. Here's what you need to know.
What is a certificate of deposit?
A certificate of deposit (CD) is a type of savings account that can offer higher interest rates in exchange for keeping your money in the account for a set period of time. For example, if you put your money in a two-year CD, you typically can't withdraw any of it (at least without incurring a penalty) for two years. When it comes time to withdraw, though, your balance will have increased thanks to the account's fixed interest rate.
There's no fee to open or maintain a CD, although there's usually a minimum deposit amount. Not every financial institution offers CDs, but you'll find them at many traditional banks, online banks, and credit unions.
Understanding how CDs work
When you open a CD and deposit your funds, you're agreeing to keep them there for the full term, which can range from a few months to five years – or more. Typically, the longer the term, the higher the interest rate you'll earn. Your money is insured by the FDIC (typically up to $250,000), so there's no risk of losing it like there is with investing.
Let's say you come into a windfall and now have an additional $25,000. You already have some money in your savings account in case of emergency, and you're only earning a 0.01% APY on that account. You want to earn more on your money, but you don't want to invest that money in it, because you know you'll want to cash some of it out in a few years. So instead, you put it in a three-year CD that offers a 1.50% APY. Three years later, your CD is worth $26,141.96.
But what if you need to close a CD early? In that case, you'll typically have to pay an early-withdrawal penalty. The penalty is usually a portion of the interest earned, so closing a three-year CD early means you might have to pay 12 months worth of interest. In the example above, that would amount to $93.23.
Types of CDs
There are several different types of CDs to meet different financial needs. Here are a few:
- Traditional CD: This is your standard CD with a fixed term and interest rate.
- High-yield CD: These CDs offer higher-than-average interest rates.
- Jumbo CD: These CDs have high minimum deposit requirements (often $100,000+) but also offer higher interest rates.
- IRA CD: This is a CD you buy with your Individual Retirement Account (IRA). You can put a variety of different investments in an IRA, including stocks, bonds, and CDs.
- No-penalty CD: These CDs don't charge a penalty fee for early withdrawals, but they typically have lower interest rates.
How are CD rates determined?
The Federal Open Market Committee (FOMC), a committee within the Federal Reserve, sets the target interest rate (known as the federal funds rate) eight times each year. While the interest rates on consumer financial products like savings accounts, credit cards, and loans aren't equal to the federal funds rate, they're often tied (and influenced) by it. This means that CD rates typically rise and fall with the federal funds rate.
While the federal interest rate sets a benchmark for CD interest rates as a whole, individual CD products can have different interest rates depending on the following factors:
- Length of CD term
- Your deposit amount
- Type of CD
- The financial institution
Pros and cons of CDs
While CDs can be the ideal blend of safety and returns, they do have their drawbacks. Weighing the pros and cons will help you figure out whether a CD is right for you.
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Opening a CD can be a great way to earn a little extra on your savings, but don't expect to see huge returns. A CD might be great for short-term savings you want to keep safe, but it's not a good idea for long-term savings goals like retirement.
CD vs. money market account
A money market account is another savings product that tends to offer higher interest rates, but there are some key differences between CDs and money market accounts to know before choosing between the two.
Certificate of deposits | Money market accounts |
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The financial takeaway
A CD is worth considering for anyone with a little extra savings they don't plan on spending any time soon. These accounts strike a good balance between returns and safety, allowing you to earn more on your money without taking on any risk.
But if you choose to go with a CD, just make sure you can keep your money parked for the full term of the CD you choose. If you end up paying an early-withdrawal penalty, the extra interest you earn with a CD isn't usually worth it. Consider your options and whether or not you'll need that money in the near future before stashing it in a CD.
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As a seasoned financial expert with years of experience in banking and investment, I've navigated the intricate landscape of financial products and services. Throughout my career, I've actively advised clients on the nuances of various investment vehicles, including certificates of deposit (CDs), and helped them make informed decisions to grow and safeguard their wealth.
Let's delve into the concepts mentioned in the article you provided, breaking down each component to provide a comprehensive understanding:
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Certificate of Deposit (CD):
- A CD is a type of deposit account offered by banks and credit unions.
- It typically offers a fixed interest rate in exchange for keeping funds deposited for a specified period.
- Withdrawals before the CD's maturity date usually incur early withdrawal penalties.
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Fixed Interest Rate:
- CDs offer a predetermined interest rate that remains constant throughout the CD's term.
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Early Withdrawal Penalty:
- If funds are withdrawn from a CD before its maturity date, a penalty is imposed, often in the form of forfeiting a portion of earned interest.
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Savings Accounts vs. CDs:
- While savings accounts offer easier access to funds, CDs generally provide higher interest rates but require funds to be held for a specific term.
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Types of CDs:
- Traditional CD: Standard CD with a fixed term and interest rate.
- High-yield CD: Offers higher-than-average interest rates.
- Jumbo CD: Requires a high minimum deposit but offers higher interest rates.
- IRA CD: Purchased within an Individual Retirement Account, offering tax advantages.
- No-penalty CD: Allows early withdrawals without penalties but typically offers lower interest rates.
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CD Rates Determination:
- Influenced by the Federal Reserve's target interest rate (federal funds rate).
- Factors affecting CD rates include the term length, deposit amount, type of CD, and the financial institution.
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Pros and Cons of CDs:
- Pros: Fixed returns, variety of terms, FDIC insurance, higher rates than savings accounts.
- Cons: Limited liquidity, penalties for early withdrawals, may not outpace inflation.
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CD vs. Money Market Account:
- Both offer higher interest rates compared to regular savings accounts.
- CDs require funds to be held for a fixed term, while money market accounts provide more liquidity with limited withdrawals.
Understanding these concepts is crucial for making informed financial decisions and maximizing returns while managing risk. Whether you're considering short-term savings or long-term investment goals, having a solid grasp of these fundamentals empowers you to navigate the financial landscape effectively.