Understanding the Basics of Certificates of Deposits

5 MIN. READ

Certificates of deposit, or CDs, are a staple for many financial portfolios. With this personal finance product, you can save money and strengthen your savings over time with guaranteed solid returns. CDs typically return higher earnings than a traditional savings account. They also can help you avoid the stock market's volatility as you watch your funds grow. How does a certificate of deposit work and what are the benefits of CDs? We cover all the basics below.

How Does a Certificate of Deposit Work?

A certificate of deposit is a savings vehicle in which you invest a fixed sum of money for a certain period. This timeframe, also called the "term," can vary from months to years. When the term "expires," the financial institution that holds your CD account will pay back the original amount plus interest.

Let’s look at an example. Say you open a CD account with an initial deposit of $2,500 for 36 months (3 years). Your interest rate of 3.15% is compounded annually. After your 3-year term, you would receive $2,743.77 (the $2,500 original deposit plus $243.77 in interest).

What's the difference between a CD and a savings account, you ask? Unlike a savings account, the money put into a CD must remain in the account for the entire term. If you withdraw it before then, you risk losing the accrued interest or paying a penalty fee.

CDs offer many benefits that can make this financial product more desirable than a regular savings account. These benefits include:
 

• Generally higher returns than a savings account, which allows you to earn more.
• A locked-in interest rate lets you know exactly how much interest you’ll earn over the CD's term.
• Insurance coverage from the FDIC or National Credit Union Administration up to $250,000, which makes your CDs, which are already considered to be low-risk investments, even safer.
• Flexible terms to fit your financial needs, which means you choose how long to invest your money.

The bottom line is that CDs offer an investment option that’s ideal for individuals who want a low-risk, predictable way to earn higher interest rates on their money. With so much uncertainty in the world and questions surrounding a recession, CDs are safer and more secure than the stock market.

How Do You Use CDs?

CDs can be part of a financial portfolio that balances safety and risk. These investment vehicles are great to use if you're saving for a specific goal, such as a mortgage down payment, a family vacation, a new car, or college.

If you're thinking about opening a CD account, here's a list of steps and considerations you might find useful:
 

1. Research CD types, terms and interest rates -- You will need this information to decide which CD type, term and interest rate will best meet your financial goals.
2. Decide what deposit amount and term you want -- Once you have picked a CD type that suits your needs, determine how much money you want to deposit into the account and for how long. Remember that when you choose a term, you are agreeing to keep the money in the account for that length of time.
3. Apply for a CD account with the institution that provides your desired term and interest rate -- In many cases, when you apply, the bank or credit union will ask you for your personal information, a photo ID, identifying information such as your Social Security number and an initial deposit.
4. Let the account "mature" -- When your CD account reaches the end of the term you agreed to, it is said to be "mature." At that point, you can withdraw the money and the interest you earned and close the account.
5. Decide if you want to extend the CD -- When your CD matures, your bank or credit union may offer you the option of renewing it for another term. They may also offer to roll the interest earned on the previous CD into the new one. The added amount allows you to earn more interest during the next term.

Before you open a CD, it's a good idea to consider whether you might need to the money before the term ends. If you withdraw funds early, you will likely lose interest earned and might be charged a penalty fee. These are things to remember as you choose a CD. Be sure you can keep those funds in your account for the term you agree to.

What Is a CD Ladder?

One popular CD investment strategy is to create a CD ladder. With a ladder, you split your savings into several CDs with different maturity dates. This strategy allows you to access part of your money at all times while maximizing your interest. In addition, laddering can help you avoid the key disadvantage of CDs: locking all your investment up for one set time.

If done properly, CD laddering provides the flexibility of a savings account and the higher yield of a CD. To get started, you take the total amount of money you want to invest and divide it into smaller amounts to be placed in CDs with staggered maturity dates. When each CD matures, the funds are placed into a new CD with a new term.

For example, say you have $10,000 you want to put into a CD. You could put that amount into four different CDs instead of one. These CDs might have the following terms:
 

• $2,500 in a 3-month CD.
• $2,500 in a 6-month CD.
• $2,500 in a 1-year CD.
• $2,500 in an 18-month CD.

After the 3-month CD matures, you could roll it into a new six-month CD that would reach its maturity nine months from the start date of the initial CD. Following this scenario would give you access to $2,500 of your savings every three months.

Again, the main benefit of CD laddering is it gives you access to part of your savings over shorter periods. In today's rising interest rate environment, laddering can also help maximize your interest earnings. Generally speaking, increasing the term of a CD will boost its yield. Laddering lets you earn additional interest on some of your money without cutting off access to all your funds for one extended period.

Things You Might Do before Opening a CD

Aside from the steps described above, here are some additional things you might want to do before you open a CD account:
 

• Make a plan for when your CD matures -- For example, decide up front whether you will roll your CD into a new one or withdraw the funds. As you make your plan, don't forget that many CDs renew automatically, typically for the same term at a new interest rate.
• Build emergency savings beforehand -- The money put into a CD shouldn’t be part of the funds you might need to cover unexpected expenses.
• Make sure you have the required deposit funds -- CDs have minimum investment amounts, so you'll need to have that money available to open an account.

At Power Financial Credit Union, our purpose is to help guide our members to better financial lives today and for generations to come. When you’re considering a CD or have questions about opening an account, we can help you find the right amount and term.