What Is a Certificate of Deposit (CD)?

A certificate of deposit, commonly called a CD, is a type of savings account that offers higher interest rates than a standard savings account. It is important to note that a certificate of deposit will require you to keep the full amount of your deposit in the account for a set term. There is also a minimum deposit amount you will need to open your account — generally $500 to $1,000.

How does a certificate of deposit (CD) work?

While traditional savings accounts have interest rates that fluctuate, with a certificate of deposit not only do you enjoy a higher interest rate but you don't have to worry about plummeting rates should things change. The downside is that you won't benefit if interest rates rise. The rate is locked in unless you opt for a certificate of deposit with more flexibility.

There are several certificates of deposit available, but the traditional one is the most common. The minimum amount of deposit varies from bank to bank and on the length of the term. Some certificates of deposit have minimum deposit requirements of less than $1,000.

Certificates of deposit offer a low-risk way to make your savings work harder for you. Certificate of deposit terms are as short as three months or as long as 10 years. It's important to carefully consider term lengths since you will not be able to access your money until the maturity date. In most cases, the longer the term you choose, the higher the interest rate. To really reap the rewards of a certificate of deposit, consider selecting a term of one or more years. Not only will you have a longer period of time to earn interest, but the rate will be higher than for a three- or six-month term.

What are the benefits of a certificate of deposit?

• High interest rates. The most attractive feature of certificates of deposit is the high interest rates. Traditional savings accounts’ interest rates aren't very high and can dip at any time. Certificates of deposit offer good interest rates and, over time, will yield a tidy sum of money. Ideally, you will invest in certificates of deposit when interest rates are at their highest, before they dip down again.
  While the returns offered by certificates of deposit may not be as impressive as other investments, they are predictable and safe. You know exactly what your return will be, provided you keep the money in the account until maturity. Some people open a certificate of deposit account for a year, then roll the original amount of money plus the accrued interest into another certificate of deposit, and in doing so continue to grow their investment over time.

• Certificates of deposit encourage savers. People who struggle with keeping money in a savings account might benefit from a certificate of deposit. There are penalties in most cases for early withdrawals, so it can motivate someone to leave the money alone. It's important to keep in mind that an early withdrawal generally means risking losing a portion of the money, or at the very least the accrued interest.
  If you have a specific goal for your savings, a certificate of deposit not only helps you achieve that goal, but also allows you to earn a significantly higher interest rate than you would get with a traditional savings account.
• Low-risk way to invest. One of the biggest draws to certificates of deposit is that the money is insured, and the interest rate is locked in and guaranteed no matter what happens with the economy. Conversely, savings account interest rates are usually not very high and can decrease at any time. In fact, certificates of deposit are better than low-risk — there is almost no risk. The risks include bank failure and the risk that interest rates go higher while you’re locked in. If you aren't in a position to risk any of your hard-earned savings, but you still want to help your money grow, then this is one of the best options.

What are the drawbacks of certificates of deposit?

• You don't have access to your money. Certificates of deposit are great ways to maximize your savings, but they aren't for everyone. Some people aren't comfortable tying up their money for months or years while they wait for the certificate of deposit to mature.
• Penalty for early withdrawal. The biggest drawback of a certificate of deposit is the penalty for early withdrawal. If you need to access all, or even a small part of your savings, you risk losing interest or paying a penalty. Thus, they are ideal for consumers who know they won't need access to their money for the full term of their deposit. The good news is there are ways around this limitation. Finding a certificate of deposit that offers more flexibility is one way to enjoy the benefits of a certificate of deposit without the penalties.
• You could miss out on higher interest rates down the road.
  Once you set up your certificate of deposit you’re locked into the rate offered. While you have the security of knowing it won't go lower, you also run the risk that you will lose out if interest rates start to rise. At that point, you have no option but to continue with the term as-is or pull the money out and incur penalties. A third option is to choose a bump-up certificate of deposit, which is discussed below.

It's always a good idea to familiarize yourself with interest rates, their patterns, the general economy and whether interest rates have been steadily rising or have peaked and are on the decline.

Other investments offer greater returns

Certificates of deposit are safe investments with no real risks. The rewards are modest. While you’ll see a much greater return than you would with a standard savings account, it isn't as significant as the return on investments that carry higher risks. They are best when left to reach maturity with a high interest rate. If you have a higher risk tolerance and are serious about growing your money, it’s worth exploring other options and speaking to a financial advisor, who can help you determine where you should be investing your money. A mix of no-risk, low-risk and higher-risk investing can help you create balance in your financial portfolio.

Lack of flexibility

With a regular savings account or another type of investment account, you have the flexibility to withdraw funds or increase your deposits. With a traditional certificate of deposit, you are limited in what you can do with your deposit. Thus, certificates of deposit are ideal for those who already have savings in a traditional account and are looking for a home for additional funds they won't need to access in an emergency, such as auto repairs, medical bills or job loss.

Certificates of deposit are great ways to securely stash funds you don't need access to while earning a locked-in interest rate that is higher than a normal savings account. They won't make you rich, but they are reliable, predictable and secure.

That said, not all certificates of deposit are created equal. If you are looking for a little more flexibility or return, it's worth investigating all your certificate of deposit options to find the one that is best for you.

When is the best time to open a certificate of deposit account?

When interest rates are climbing and you find yourself with a chunk of money that you don't need access to for a while, consider parking it in a certificate of deposit account. Certificates of deposit are great ways to help you achieve specific savings goals. If you have received some kind of windfall, such as a settlement or bonus, and you aren't sure what to do with it, consider a short-term certificate of deposit while you decide. If you have a set amount of money saved for something important, such as a down payment, tuition or vacation, but don't plan on using it for a year or more, a certificate of deposit not only helps you hold onto the money, it also earns more interest than your standard savings account. Keep in mind that the longer the term you can commit to, the greater the reward.

5 different certificates of deposit

Traditional certificates of deposit

Traditional certificates of deposit are popular with people who are comfortable sticking to their terms and not making any changes. These certificates of deposit come in varying term lengths, ranging from one month to 10 years, offer competitive interest rates and impose penalties for early withdrawals. You cannot add funds to traditional certificates of deposit, nor can you withdraw funds without incurring penalties.

Interest rates will vary depending on the institution and are locked in for the length of the term. Despite the lack of flexibility, traditional certificates of deposit are still reliable and safe choices that are readily available through most financial institutions.

High-yield certificates of deposit

As the name suggests, high-yield certificates of deposit offer higher interest rates than traditional certificates of deposit (just like how high-yield savings accounts offer higher interest rates than traditional savings accounts). You are more likely to find high-yield certificates of deposit at online banks or credit unions than at traditional banks. Shop around to find the highest rates. Interest rates are the main distinguishing factor for this type of certificate of deposit. As with other certificates of deposit, you will find the highest interest rates are reserved for longer terms.

Bump-up certificates of deposit

One advantage of a certificate of deposit is the set interest rate. A set rate is ideal in situations where interest rates are on a downturn. However, there are times when interest rates are on the rise and it can be frustrating to be locked into a lower rate.

That is, unless you choose a bump-up certificate of deposit. With this type of CD, you have the option to bump up your rate to the current rate so you don't miss out on rising interest rates.

Be aware that some banks will only allow you to do this once, while others may allow you to do it more often. It's also important to note that your starting interest rate may be lower, so in some cases, you may find that you haven't gained much of an advantage in the long run. This is where doing your homework pays off.

Add-on certificates of deposit

Another more flexible option is known as an add-on certificate of deposit. This type of CD offers the option of adding funds to your initial deposit. Other than this, you have all the same features of a traditional certificate of deposit; however, you might find the interest rate to be a bit lower. You will need to read the fine print to find out how many times you can use the add-on feature, and you will also find these certificates of deposit are not widely available. Still, it’s a good option in the event that you’re starting out small with your deposit and may be able to add to it later.

No-penalty certificates of deposit

A no-penalty certificate of deposit, also known as a liquid certificate of deposit, offers the option to withdraw your deposit before the maturity date without a penalty. This decreases the risk of an already low-risk investment.

If an emergency makes it necessary to withdraw the money from your account, you won't lose any of your funds or the interest you have accrued so far. The downside is you will find these CDs have a lower interest rate, reducing your overall return. However, if you are averse to having your money locked up and want more flexibility, this is a valid option.

It's a good idea to run the numbers on the different types of certificates of deposit that are available. While a no-penalty CD or a bump-up CD might sound good, you may find that a short-term high-yield or traditional certificate of deposit is the better way to go.

Where is the best place to get a CD?

Most people look to their own banks or credit unions for certificates of deposit, but it's worth noting that online banks and brokerages are also valid options. In many cases, you will find more attractive interest rates from online banks, and there are benefits to purchasing CDs from brokerages. While there is nothing wrong with sticking with your own bank, it’s wise to shop around for other brick-and-mortar institutions and online options. The idea is to have the highest yield for your investment in a term length that works for you.

Different financial institutions have different minimum amounts. Most banks require a deposit of $500 to $1,000, but some have no minimum. If your own bank's terms don't work for you, keep looking for one that offers the best rate, a term you are comfortable with and a minimum amount that works for you. If you want to start small, there are some online banks that offer certificates of deposit with no minimums.

Online banks

If you are reluctant to shop for a certificate of deposit at an online bank, you shouldn't be. Provided the bank is federally insured, your money will be just as safe as it is in your brick-and-mortar bank. In fact, an online bank may provide you with greater flexibility, lower fees and higher interest rates, so they are definitely worth checking out. There are many well-known, reputable online banks to choose from. As always, vet them by doing your research. Make sure
they are insured by the Federal Deposit Insurance Corp. (FDIC), check their reviews and always read the fine print before committing your hard-earned money. The standard insurance amount is $250,000 per depositor, per insured bank.

Brokerage firms

Another alternative to a traditional bank is to open an account with a brokerage firm. They offer competitive rates that are often higher than the bank’s rates. To make it even more attractive, you won't incur early withdrawal penalties with a certificate of deposit from a brokerage since you can sell it back to them before the maturity date if you need access to the funds. You could technically lose a little money, depending on current interest rates, or you could increase your profits if rates have dropped. Depositors don’t need to apply for FDIC insurance. Coverage is automatic whenever a deposit account is opened at an FDIC-insured bank or financial institution. If you are interested in FDIC deposit insurance coverage, simply make sure you place your funds in a deposit product at the bank.

Should you build a certificate of deposit ladder?

When used strategically, CDs are solid methods of investing that allow you to save money and maximize higher interest rates. One way you can get the most out of CDs is to use a certificate of deposit ladder.

This strategy involves taking a sum of money and splitting it between five CDs of varying lengths. Rather than putting $10,000 in one certificate of deposit for five years, you put $2,000 in five certificates of deposit. The idea is to choose a shorter term, reinvest the original amount plus interest into a new certificate of deposit and then stagger the maturation dates so you have each one maturing one year after the next. This means you always have a certificate of deposit maturing that you can either cash out or reinvest. While juggling so many maturity dates may not appeal to everyone, it is an excellent strategy to keep your money working hard for you.

Choosing the best certificate of deposit

Now that you have a basic idea of how a certificate of deposit works, the different types of certificates, and their benefits and drawbacks, how do you choose the right one? Here are some questions to ask:

How long can you realistically commit funds to a CD account?

This is important because you don't want to incur penalties or lose interest if you have to terminate the account early. It is better to choose a shorter term that you can complete.

Are you comfortable with a traditional account or would a bump-up or add-on account be better for you?

While these accounts offer more flexibility, they might not offer the highest interest rates.

Try answering these questions to find out if a CD is a good strategy for your situation: How much are you willing to set aside? Should you split the money between more than one account? Have you checked into the ladder strategy?
Have you shopped around for the best rates? Are you willing to open an account with an online bank or brokerage firm to get more attractive rates, or are you more comfortable sticking with your current bank?

If you are looking for a safe way to save money and earn interest that is above the rate you would get with a regular savings account, then a certificate of deposit is ideal. It's important to weigh the benefits against the drawbacks so you can make the most educated decision. Many people find that a certificate of deposit is an ideal way to keep their money safe and earn some interest.