A certificate of deposit, commonly known as a CD, is a popular type of savings account offered by banks and credit unions. It offers a secure way to grow your savings, provided you’re willing to lock your money away for a specified period. While the concept might seem straightforward, there’s a lot more to understand about CDs to determine if they’re the right choice for your financial goals.
What is a certificate of deposit?
A certificate of deposit is a time deposit where you agree to keep a certain amount of money in the account without making any withdrawals for a predetermined period, known as the term. In exchange, the bank or credit union pays you interest at a fixed rate. At the end of the term, known as the maturity date, you get back your principal amount along with the accumulated interest.
How Does a CD Work?
When you open a certificate of deposit, you essentially loan your money to the bank for a set period. In return, the bank agrees to pay you interest. The interest rate on a CD is usually higher than what you’d earn from a traditional savings account because you’re committing to not withdraw your money until the certificate of deposit matures.
Brad Stark, a certified financial planner and co-founder of Mission Wealth, explains that CDs can also be purchased through brokerage accounts. Many brokerage firms have relationships with various banks, which allows you to spread your investments without opening multiple accounts.
Pros of CDs
Higher Interest Rates
One of the most significant advantages of CDs is the higher annual percentage yield (APY) compared to traditional savings accounts. However, the rate you get depends on the federal funds rate at the time you open the certificate of deposit. Typically, the longer the term, the higher the interest rate.
Safety
CDs are considered very low-risk investments. If you open a certificate of deposit at a bank or credit union insured by the Federal Deposit Insurance Corp. (FDIC) or the National Credit Union Administration (NCUA), your deposit is insured up to $250,000 per depositor, per institution. This means even if the bank fails, your money is safe.
Flexible Terms
CDs come in a variety of term lengths, ranging from a few weeks to several years. This allows you to choose a term that aligns with your financial goals. Whether you’re saving for a down payment on a house or want to park some cash safely for a short period, there’s likely a certificate of deposit term that fits your needs.
Cons of CDs
Limited Liquidity
One of the main drawbacks of CDs is the lack of liquidity. Once you deposit your money, it’s locked away until the term ends. If you need to access the funds before the maturity date, you’ll likely incur a penalty, which can eat into the interest earned and even the principal in some cases.
Opportunity Cost
CDs offer safety and predictability, but this comes at the cost of potential higher returns from other investments like stocks or bonds. If you’re young and have a long investment horizon, the opportunity cost of locking money in a certificate of deposit instead of investing in higher-yield options can be significant.
Fixed Interest Rates
While a fixed interest rate can be a pro in a declining interest rate environment, it can be a con if rates rise. You’re locked into the rate you agreed to at the start, so if interest rates go up, you’ll miss out on the higher returns.
Inflation Risk
CDs provide a fixed return, which can be a disadvantage in times of rising inflation. If inflation outpaces the interest rate on your certificate of deposit, your purchasing power could be eroded over time.
Making Money with CDs
The primary way to make money with CDs is through the interest earned over the term of the deposit. This makes CDs suitable for those looking for a low-risk investment to save money over the long term. However, it’s crucial to ensure you won’t need to access the money during the term, as early withdrawals incur penalties.
Is a CD Worth It?
For some, CDs can be an excellent investment. They offer a higher interest rate than checking or traditional savings accounts, making them a good option for those seeking a risk-free investment with a modest return. However, it’s essential to weigh the pros and cons, considering factors like your investment horizon and risk tolerance.
CD Laddering: A Strategy to Consider
Certificate of deposit laddering is a strategy where you divide your investment among multiple CDs with varying term lengths. This approach creates a staggered maturity schedule, providing periodic access to your money while still earning interest. Scott Van Den Berg, a CFP at Century Management, highlights that a certificate of deposit laddering can enhance liquidity and potentially increase returns.
Here’s how the certificate of deposit laddering works: Instead of putting all your money into a single CD, you split it across several CDs with different maturities. For example, you might invest in one-year, two-year, and three-year CDs. When the one-year CD matures, you can either withdraw the money or reinvest it in a new three-year CD, maintaining the ladder. This strategy ensures that you have funds becoming available periodically, which can be particularly useful for managing unforeseen expenses.
What You Need to Open a CD
Opening a CD requires several pieces of information and documentation:
Social Security Number (SSN) or Individual Taxpayer Identification Number (TIN): This is necessary for tax reporting purposes.
Date of Birth: Proof of identity and age.
Government-Issued ID: A driver’s license or state ID to verify your identity.
Proof of Address: Utility bills or a lease agreement to confirm your residence.
Contact Information: Phone number and email address.
Funding Account Information: Routing and account numbers for the account from which you’ll transfer the initial deposit.
CD Rates and Terms
CD rates can vary widely depending on the financial institution and the term length. As of January 2024, the national average rate for a one-year CD is approximately 1.86%, while a five-year CD offers about 1.41%. However, by shopping around, you can find CDs with much higher rates, sometimes exceeding 5%.
Taxes on CD Earnings
Interest earned on CDs is subject to federal and state income tax. If you earn $10 or more in interest in a year, the bank will issue a 1099-INT form, which you’ll need to report on your tax return. For CDs with terms longer than one year, you must pay taxes on the interest accrued each year, even if you don’t receive the money until the CD matures.
Early Withdrawal Penalties
CDs come with a commitment to leave your money untouched for the entire term. If you need to withdraw funds early, you’ll face penalties, typically amounting to several months’ worth of interest. This can significantly reduce your overall returns, so it’s crucial to ensure you won’t need the money before opening a CD.
The Bottom Line
A CD can be a smart move for those with a low-risk tolerance and a shorter investment horizon. They provide a safe and predictable way to grow your savings, especially if you’re looking for a guaranteed return. However, it’s important to plan ahead and make sure you won’t need to access the funds before the CD matures to avoid penalties.
When considering a CD, remember that they aren’t the only option available. Explore other investment opportunities to create a well-diversified portfolio that aligns with your financial goals and risk tolerance. By doing so, you can maximize your returns while still maintaining a level of safety in your investments.
