Certificate of deposit: What is a CD and is it right for you?
Why do people invest their money? It’s likely because they’re saving for something—a trip, a home, a child’s college education—or simply because they don’t want to work until they’re 108. People earn money by working, but putting your money to work through investments, like CDs, is also an excellent way to build wealth and help you afford the things you want in life.
Investing is the most effective way to grow your money long term, but risking what you already have for the prospect of something more in the future can be scary. Couple that with the complexities of the financial markets, and it’s easier to stuff some cash under your mattress.
The truth is investing doesn’t have to be complicated. Some conservative options can help you earn extra cash without pushing you beyond your comfort zone. Seasoned and novice investors can benefit from safer, simple choices.
What is a CD, and how does it work?
A certificate of deposit (CD) is a promissory note issued by a bank or credit union. It comes with a future maturity date and a fixed interest rate. When you invest in a CD, you, as the investor, agree to loan your money to the issuing institution for a specific period of time and a predetermined rate of return.
When you purchase a CD, you give up access to your funds until the maturity date. For forfeiting your liquidity, you earn compensation in the form of interest. Once it matures, the bank refunds your initial investment (the principal) plus your earned interest.
CDs are issued for different terms. Long-term CDs typically offer a higher rate of return compared to short-term CDs. Why? Because your restricted access to the funds is for a longer timeframe, and the longer you’re required to hold your investment, the higher level of risk and uncertainty you assume.
How risky are CDs?
On the spectrum of risk and return, CDs are considered conservative investments. The Federal Deposit Insurance Company (FDIC) backs federally-insured bank CDs, and the National Credit Union Administration (NCUA) guarantees credit union-issued CDs. Even if the issuing institution collapses, your investments are protected.
The risk that you assume with CDs is interest rate risk. When you invest in a CD, you agree to a specified rate of return. As the financial markets fluctuate in response to economic and political factors, you want your CD’s rate of return to remain competitive. If rates rise, your current investments could be locked into a lower rate for an extended period. While you don’t risk losing your investment and earned interest, you could miss the opportunity to earn more money than with your current CD.
One way to reduce that level of risk is called laddering. You can stagger maturity dates among several CDs so that matured deposits can be reinvested at potentially higher rates, and you can gain periodic access to cash if necessary.
How is it different than a Money Market or savings account?
Like a savings or Money Market account, CDs allow you to save towards a goal, like a down payment on a house, a car, or a vacation. Unlike CDs, savings and Money Market accounts allow you to vary your balance by making additional deposits plus a maximum of six withdrawals per month. CDs, however, require only one deposit that stays in the account until its maturity date—whether it’s six months or five years from now. Because you give up access to your funds, they generally offer a higher rate of return versus traditional savings accounts or Money Market accounts.
When should I open a CD?
CDs are advantageous in certain situations. If you have a stockpile of cash that you don’t need now but want in the future, maybe for a house or a car, a short-term investment like a CD is helpful. You don’t run the risk of losing money if you were to invest in something like the stock market. They’re also beneficial if you tend to lean more conservatively with your investments.
If you notice your checking account balance is running low, it can be tempting to dip into your savings account. If you lack the discipline to not touch your savings account, the fixed period of a CD—and penalty for early withdrawal—can provide a deterrent to frivolous spending.
What happens when my CD matures?
When your CD matures, you typically have a few options. Your bank or credit union will notify you of your choices one to two months before its maturity date. You can roll over to a new CD with the financial institution, typically into a term that is similar to the one you already have. You can also transfer the earned funds to a checking or savings account or a Money Market account with your bank or credit union. Lastly, you can transfer those funds to an external account or receive a paper check.
What if I withdraw my funds early?
As with any investment, familiarize yourself with the fine print. A common concern with CDs is penalties for early withdrawal. If you experience hardship and have to withdraw cash from your CD, it could significantly affect your earned interest or even your principal. Most financial institutions assess an early withdrawal penalty (EWP) before your funds are distributed based on the agreement set upon when you initially deposited funds. EWPs are typically charged as a certain number of months’ interest. For example, you may have three months’ interest deducted if you withdraw from your 12-month CD before it matures.
Every bank or credit union has different EWPs, so it’s best to check with your financial institution’s policy. There are also specialty CDs like penalty-free CDs, Bump Up or Raise Your Rate CDs, and IRA and Jumbo CDs.
If you’re considering an investment, speak with your financial advisor to determine which options will meet your individual needs—in the short and long term. You can schedule a meeting at no cost and no obligation with a financial advisor at Georgia’s Own to discuss your investment plans.