What Is a Certificate of Deposit (CD)?

What Is a Certificate of Deposit (CD)?
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Like most people, you probably want to make the most of the money you have by growing it as easily as possible. Well, you’re in luck: When it comes to saving money, one way to effortlessly help it grow is to open a certificate of deposit account, or CD.

What Is a CD?

A certificate of deposit, or CD, is a type of time deposit issued by financial institutions, such as banks and credit unions. In exchange for a fixed interest rate, you are required to keep your money in the account for a specified amount of time. Except for IRA or Roth IRA CD accounts, CDs are taxable as income. A CD is a low-risk investment you keep your cash in for a longer period of time.

Depending on the financial institution, a certificate of deposit term length can range anywhere from one month to several years. The advantages and disadvantages of a certificate of deposit include a guaranteed rate, but the money you invest is tied up for the term of the CD. As an account holder, you are not allowed to withdraw from the CD until the maturity date — if you do, you will be charged a penalty. However, CDs are low-risk investments because the interest rate is locked in, so you’re guaranteed a certain return.

Learn about the different types of CDs available, so you can choose the right one for your financial strategy.

See: The Highest CD Rates in Every State

CD Rates and Terms

CD rates are generally higher for longer-term accounts. Simply put, that means a five-year CD will earn more in interest per year than a two-year CD. As you can see, you basically get rewarded for allowing the institution to tie up your money for a longer period of time.

Another factor that will affect your CD rate is the type of product you choose: Not all CDs are created equal. Choosing the right CD for your budget, needs and goals means you’ll have to carefully weigh your options.

The amount of money you put into your CD often impacts how much interest you’ll earn — so the more you invest, the higher your rate will be. For instance, Chase offers customers who fund a 60-month CD with $100,000 or more 0.25 percent more interest than those who invest less than $10,000 in the same 60-month CD.

If you’re trying to maximize your returns for retirement and can afford to tie up your funds for several years, you might want to consider investing more money in a longer-term CD. The drawback here is that if interest rates go up, you might not be able to take advantage them since you’re locked into a preexisting, lower rate. However, there are ways CD investors can still jump on higher rates, including a strategy called “laddering,” which is explained in this article.

Types of CDs

A number of options are available when it comes to CDs, so it’s likely you can find a CD strategy that suits your financial goals. Check out the different types of CDs so you can better decide what would be best for you.

Traditional CD

A traditional CD gives you term options or the duration of your deposit. Chase, for example, offers CDs terms for one month all the way to 120 months. However, withdrawing your money from a CD before it “matures” – or when your term ends — comes with a price tag. Early-withdrawal penalties vary depending on the financial institution, so make sure you check with your bank or credit union to find out the exact numbers.

Bump-Up CD

A bump-up CD is exactly what it sounds like: a CD account that lets you bump up your rates during your term. In the event that interest rates rise on a similar CD, you can switch your rates to the higher one as long as your CD hasn’t matured yet. Typically, banks allow one bump up per CD term. This is a smart option if you’re worried about getting stuck with low interest rates when higher CD interest rates are available.

Callable CD

Callable CDs represent an opportunity for banks to save money when rates fall and a way for investors to possibly earn more interest than they would on other types of CDs, like traditional ones. Basically, a callable CD allows banks to release the CD before its maturity; this would typically happen if interest rates start falling. For taking this risk, financial institutions reward investors with higher interest rates.

When you invest in a callable CD, the bank or brokerage provides you with the maturity date and the call date; the call date is the CD issuer’s first opportunity to call back the CD, cash you out and pay you the interest you are owed up until the date it was called.

If the institution misses or passes on its call date, it must wait the length of the original call date to call the CD again. For example, if your CD’s call date is four months from the time it was issued, the bank has a chance to call the CD once every four months.

Liquid CD

Liquid CDs offer people the flexibility of withdrawing a portion of their money from a CD before it matures. This is a great option for people who want to lock in a specific interest rate but aren’t sure if they will need some of their funds before the term ends. The price for enjoying this kind of liquidity is usually a lower interest rate than what is available for other types of CDs.

Zero-Coupon CD

Another way to get higher interest on a CD is to invest in a zero-coupon CD. These accounts accrue annual interest but do not pay it out — instead, the interest gets reinvested so that you then earn interest on a larger deposit. As your principal grows, so does your interest. These CDs often offer higher interest rates; however, you will have to pay taxes on all the interest that is reinvested into the CD.

CD Laddering Strategy

A CD ladder is a great way to invest long-term, still build capital and keep some of your funds liquid. Basically, investors begin by distributing their investment capital over multiple CDs with increasing terms.

For instance, if you have $40,000 to invest, you might put $10,000 in a one-year CD, $20,000 in a two-year CD and the other $10,000 in a five-year CD. Obviously, the longer the term, the higher the interest rate is on the CD. You can have as many rungs on your “ladder” as you like, so you are free to invest in multiple CDs and take advantage of higher rates.

Once your one-year CD matures, you have the option of cashing out or reinvesting your money into another CD — one with a longer term that will net you more interest. At this point, you’ll only have one year left to wait on your two-year CD. CD laddering is a smart strategy to keep your money growing.

Find Out: How CD Laddering Works

The Bottom Line

You can invest in CDs in many ways to get the most out of today’s interest rates and minimize loss. Even the riskiest CDs won’t compromise your principal investment, and all types guarantee some return. Since CDs usually come with FDIC insurance, your money is guaranteed up to $250,000 — be sure to double check that your financial institution is backed by the FDIC. This means that even in the unlikely event the bank goes belly up, you know you’ll get that much back.

The most important thing to consider when you choose your CD is the likelihood of needing your funds before the CD reaches maturity. Because you don’t want to pay a penalty for withdrawing your money early, make certain you can afford to tie up your investment for the length of the term.

Keep Reading: 8 Ways Your Money Habits Are Ruining Your Relationship

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