A reader recently asked the following question about certificates of deposit:
I’m very new to all this. What exactly is a CD? Can you make deposits into it, like a savings account? Or do you start with a set deposit amount and just leave it to accrue interest? Would these work for my kids savings accounts? Any info is appreciated. Thanks.
It’s a great question, because all the various deposit account types can be confusing. And there are some important differences between a CD and a savings or money market account.
A certificate of deposit (CD) is a Federal Deposit Insurance Corporation (FDIC) investment that is available at banks and savings and loans institutions. It is essentially a promissory note issued by a financial institution in which the customer agrees to lend the bank a certain amount of money for specified period of time for a predetermined rate of interest. CDs can be issued in any denomination and generally have maturities ranging from one month to five years; generally speaking, the longer the maturity of the CD, the higher the rate of interest. If the funds are needed before the CD matures, it is possible to withdraw them but the customer will incur a penalty. The penalty at every bank is different and can range from a fee or a cut off the stated interest rate, so be sure to inquire before investing.
For example, if a customer purchases a $10,000 CD with an interest rate of 2% compounded annually and a term of two years, at the end of one year, the CD will have grown to $10,200 ($10,000 * 1.02). CDs in denominations of less than $100,000 are called “small CDs” while CDs greater than $100,000 are called large CDs or “jumbo CDs.” More times than not, CDs pay higher interest rates than online savings account. Why? The bank is rewarding you with a higher interest rate because of the expectation that you will keep your money in the bank for a specified period of time. By doing so, you are giving the financial institution the ability and the time to use your money for other purposes such as lending it to other customers or investing it.
Certain CDs permit monthly deposits and withdrawals prior to their maturity. These CDs are called liquid CDs and are offered by various financial institutions. The number of withdrawals in such accounts is often limited and customers must maintain a certain balance. Beware, however, that the rate on liquid CD accounts is often lower than on a traditional CDs, as the customer has the luxury of withdrawing their funds. Additionally, such accounts sometimes require minimum deposits.
Other types of CD accounts include bump up CD accounts which allow customers to take advantage of higher returns when interest rates rise. For example, if a bank offers a two-year CD with a bump-up option and a similar term traditional CD at a quarter point higher interest rate, you would want interest rates to rise significantly more than a quarter point during the two-year term to take advantage of the bump-up CD.
A CD cannot really be viewed as a savings account because in a savings account people can access their money at any time without being penalized, whereas to get the full benefits of a CD you must keep your money locked up (unless you want to incur a penalty) until maturity. Again, to compensate the customer for leaving the money untouched, the bank pays a higher interest rate on a CD than it would on a savings account. One alternative is a no-penalty CD, where you can withdraw the CD at anytime without an interest penalty. Again, these type of CD’s are going to have a lower than normal interest rate.
Upon maturity of a CD, the customer will normally have a window during which he/she can decide if the proceeds should be reinvested in another CD or taken out of the bank. If the bank is not instructed otherwise, it will automatically reinvest the proceeds into a new CD.
If you have money that you do not believe you will need to access in the near future and you are a rather risk-averse investor, a CD is a good option for you. It is insured by the FDIC and is certain to yield a stated rate of interest. Check out the best online CD rates to invest in your own CD today.
Published or updated March 16, 2011.
