What Exactly is a Certificate of Deposit?

Bank accounts seem pretty cut and dried to some, but much more confusing to others. Take, for example, the fact that you can get a basic savings account and checking account. Many people feel this is where banking begins and end. You have money to spend on expenses, and money to save for the future. That’s all you need, right? Well, yes and no. You can open a savings account to keep your funds and earn some interest on them, but savings rates are typically very low. This means that you’re certainly not getting much for your efforts, and that makes the savings game a little less fun. Unless you have hundreds of thousands or even millions in your savings account, the rate of return is just not that impressive. After all, if you take a look at standard savings interest rates these days, the return is not that amazing.

According to Forbes, most online banks are offer interest rates 0.75% to 0.95%, which is higher than many traditional banks. Some banks offer high-yield savings accounts with interest rates above the 1% mark, but that is a small and very depressing number in general. That’s why many people are looking for an alternative method to traditional savings accounts. Perhaps that’s why you’re interested in the concept of a CD, or Certificate of Deposit (CD from this point forward). CDs are one of the better ways to improve your interest rates and earn you more of a return on your ‘investment,’ and they’re not all that different than a traditional savings account when you get down into it.

With that in mind, what is a Certificate of Deposit? How does it work? Where do you get one? What’s the catch? We have all the answers you are looking for right here, summed up so that you can see how a CD will change your income and your savings account for the better.

What is a CD?

A CD is a type of savings account. You get to deposit money into it, you get to earn interest on it, and you get to see results with higher rates than most regular savings accounts. The way that it differs is that a typical savings account allows you to make deposits whenever you want. You can even make withdrawals whenever you want in many instances. With a CD, however, you have to keep your money in the account for a certain amount of time – predetermined when the account is opened – and leave it alone. If you choose to withdraw your funds before the timeframe is over, you pay a hefty penalty. Consumers get to choose the amount of time in which they lock away their funds, though it is most often anywhere from 3 to 6 months. You can do longer periods and you can do shorter periods. And you can get a higher rate the longer you keep your money locked in your CD.

What are the penalties?

The penalties on a CD vary. It all depends on the terms you agree to with your financial institution. For example, you might forgo anywhere from 3 to 6 months interest on your early withdrawal, a flat fee or something different. We cannot tell you precisely what the amount of the penalty will be based on the many contributing factors, but we can tell you that it is imperative to know what penalties you face when you open an account of this nature. Don’t let them surprise you if there is some sort of emergency that requires you withdraw your funds early.

Laddering your accounts

The problem with CDs for most people is that they tie up the funds you have in savings. Many are uncomfortable with the concept of tying up funds and making them largely unavailable for long lengths of time, which is often a deciding factor when it comes to long-term CDs. For example, you might love the idea of having a 3 to 5 year CD that offers a very high interest rate, but you don’t feel comfortable with your money being tied up in an account in which you cannot access it for a certain amount of time.

That’s why many people use the ladder method. Let’s take this for example; you have $20,000 to save. You can split it up and open 5 CDs. You can open a 1, 2, 3, 4 and 5 year CD with $4000 in each account. At the end of your first year when your account is available to touch, you then deposit that money into a new 5-year CD. What this does is allow you to access your accounts every single year while still taking advantage of the high interest rates in bigger accounts. It’s a great way to ensure that you always have access to some of your savings on an annual basis, and it’s going to go a long way to helping you feel more comfortable with your savings.

Types of CDs

  • IRA CD
  • Jumbo CD
  • Variable-rate CD
  • Callable CD
  • Low/No-Penalty Early Withdrawal CD

Depending on your financial institution, you might have your pick of different CDs. These are the most commonly offered CDs at any given bank, and each one is worth checking into. We cannot tell you which one to choose, since we are not privy to your personal financial situation. However, when choosing the type of CD you want from your bank, consider your financial situation, the amount you have to offer to your account and precisely when you want to access you money.

When you are more understanding of what these kinds of accounts have to offer, it’s far easier to understand what works better for you in terms of investments, savings and returns. The moral of the story, though, is that opening a CD or two is typically far more cost-effective than opening a traditional savings account, which is what’s going to make your financial life that much simpler and more profitable.