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CDs (Certificate of Deposit) - What are they and how do they work?

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Traditional savings accounts are outstanding for short-term goals but typically don't offer the highest return on your investments. If you're looking to invest in something with a higher yield, then certificates of deposit (CDs) may be worth considering.

There are several factors to consider when weighing your options:
  • What CDs are and how they work
  • Advantages and disadvantages of CDs
  • How to decide if and when you should invest in CDs
  • How to compare CDs
  • A bonus tip for getting the most out of your CDs
Learning the essentials about CDs will help you decide if they are the right investment option to meet your financial goals.

What is a certificate of deposit, or CD?

Simply put, a CD is a savings account with a set maturity date. Unlike a regular savings account, when you invest in a CD, you are committing to keeping the money in the account for an agreed-upon period (usually ranging from three months to five years). Credit unions and banks thus offer higher interest rates in exchange for this commitment.

Consequently, if you can keep the money in your CD account for the entire period, you will receive a higher return on your investment than you would with a traditional savings account. Since the credit union or bank holds your investment for a guaranteed period, CDs are mutually beneficial to both the investor and the institution.

For example, a $100,000 deposit in an average savings account might earn you an annual interest rate of 1%, or $1000. On the other hand, if you invest that same $100,000 in three-year CD, you could expect to earn up to 4%, or $4000.

It's simply a safer way to earn more money on your investments.

Advantages and disadvantages of a certificate of deposit

Certificate of deposit pros and cons should be considered carefully.

Advantages include the following:
  • Higher returns. As noted, CDs typically offer a higher rate of return than traditional savings accounts.
  • Safety. CDs are generally NCUA and FDIC insured up to $250,000, meaning your money is safe regardless of what happens in the market.
  • Flexibility. Banks and credit unions usually offer a variety of different terms for CDs, making it easy to find one that suits your exact needs and timeline.
Disadvantages include these factors:
  • Early-withdrawal penalty. If you need to access your money before the CD matures, you'd be breaking the agreement and hence be liable for a penalty fee.
  • Low liquidity. Since CDs require you to commit for a given period, they may not be ideal if you are looking for quick access to the funds.
  • Inflation risk. Inflation affects the value of your money over time, so CDs may not be as beneficial if inflation is high.
Should you invest in CDs now?

CDs can be an excellent investment option, depending on your needs. If you can commit your money for a specified period and are looking for higher returns than traditional savings accounts offer, then CDs may be the right option for you. However, it's essential to consider potential risks such as inflation.

If you can't commit to a long-term investment, it may be better to wait until the market is more stable, because an early-withdrawal penalty may outweigh any potential gains.

How to take advantage of CDs most effectively

Once you've determined that CDs are a suitable investment vehicle for you, there are a few steps that can make the process smoother:
  • Shop around. Compare interest rates and terms from different banks and credit unions using tools such as Certificate of Deposit Calculators, to ensure you receive the best deal for your money.
  • Read the fine print. Make sure to read all the terms and conditions of your CD agreement before signing anything.
  • Set up mobile banking in advance. Establishing mobile banking ahead of time ensures that you're ready to strike, securely and conveniently, when CD rates are most optimal.
Bonus Tip: CD laddering and how to use it to your advantage

After weighing the advantages and disadvantages of a certificate of deposit, many investors find that the best way to maximize returns from CDs is to use a technique known as “laddering.” This involves breaking up your investments into smaller chunks and investing them in several CDs with different maturity dates.

For example, you could make a $100,000 investment in $20,000 chunks, utilizing five CDs with varying maturities. This staggered technique will give you regular access to your funds, and it can also help reduce the risks associated with long-term investing. If interest rates begin to rise, you can reinvest at a higher rate as each CD matures.

In short, if you are looking to maximize your returns while still also emphasizing safety and security long-term, CDs can be an excellent choice. Learn more about the options available and how you can make the most of your investments today!