A CD (certificate of deposit) sold by either a bank or credit union is generally considered one of the safest ways to save money while earning interest.
The reason a CD is low-risk is primarily due to the FDIC insurance (or NCUA insurance if issued by a credit union) that the financial institution has. This protects your funds up to $250,000 in the event of the bank or credit union’s inability to repay your principal investment plus any interest accrued.
CDs come with a set term (amount of time) and a fixed interest rate or APY (annual percentage yield). Terms typically range from 6 months to 5 years, but shorter term deposits of 1-5 months as well as longer term deposits of up to 10 years may be offered by some institutions.
How CDs Work
When you open a CD at a bank or credit union you are agreeing to keep your money tied up for a predefined period of time in exchange for a predefined fixed interest rate.
APY and Interest
On the day your account is open and funded, you will start earning interest. Interest is normally compounded either daily, monthly or quarterly.
Interest is then returned to the bank CD and added to the principal for further compounding. The APY is the overall yield you will receive annually taking into account compounding interest. This is why you generally see interest rates and APYs shown together when shopping around for bank CDs and also why the interest rate is generally a smaller figure than the APY.
For example, you might see something like:
In this example above you’re earning an interest rate of 2.96% but after compounding interest is taken into effect the overall take home yield (or APY) at the end of the year is 3.00%.
Some savers like to have their interest payments sent to them (generally by ACH transfer) rather than added back to the principal for further compounding. Generally speaking, many banks and credit unions allow for this, but just remember you won’t receive the full APY but rather just the interest rate, since interest payments will be sent to you rather than added back to the deposit.
Prior to the maturity of your CD, the bank or credit union will send you a notice that your CD is going to mature soon.
Upon maturity you will generally have 7 – 10 calendar days to make any changes you would like to the CD. This includes changing the term, adding or withdrawing funds or closing it out entirely. This 7 – 10 day window is referred to as the grace period.
Early Withdrawal Fees
If you need access to your funds prior to your CD’s maturity date, you will almost always incur an early withdrawal penalty fee. The details of these fees vary by institution but have the potential to drastically eat away at any interest you’ve earned and even your principal.
This is why you must be sure you can tie up your funds for the period of time you select when opening a CD.
📌 Important – Before considering a certificate of deposit at a bank or credit union be sure you have liquid cash in a savings account that can be accessed in case of an emergency. Most financial advisors recommend 3 – 6 months worth of living expenses.
Terms, Deposit Size and APY
As mentioned, CDs tend to come with terms (or durations) of 6 months to 5 years.
In exchange for locking up your funds for longer periods of time, banks and credit unions will generally give you a higher APY. Therefore yields on 5 year CDs, for example, are almost always going to be higher than yields on 6 or 12 month CDs on average.
Another factor that may have implications on your overall APY is your deposit size. Many banks and credit unions offer “Jumbo CD” rates for larger deposits. There is no exact dollar amount that qualifies as a jumbo CD but rather banks and credit unions set these amounts themselves individually. Oftentimes a jumbo CD will be $100,000 or the FDIC-insurance maximum of $250,000, but again, each institution is different in defining what a Jumbo CD is for them.
Banks and credit unions may also offer tiered interest rates that vary by deposit range.
For example, you may see a rate table of offers from a bank or credit union that looks like the following:
|12 month||$1 – $9,999||1.75%|
|12 month||$10k – $$49,999||2.00%|
|12 month||$50k – $99,999||2.25%|
|12 month||$100k +||2.50%|
In the table above, you’d receive the best annual percentage yield with a deposit size of $100,000 or more and the lowest APY with a deposit size of less than $10,000.
Alternatives to Consider
If you’re still on the fence about opening a CD, there are a handful of alternative, low-risk options to consider.
- High yield savings account – Along with a money market account, high yield savings accounts are FDIC-insured, variable rate deposit accounts that earn interest. These accounts may also be referred to as online savings accounts since they can almost always be opened and managed completely online. Although CDs generally pay higher interest rates than these accounts, the trade-off is you’ll have much easier access to your cash with a high yield savings.
- I Bonds – Purchased through the TreasuryDirect, I Bonds or Series I Savings Bonds are designed to hedge against inflation. Consumers can only purchase up to $10,000 worth in any calendar year, but the rate is currently sitting at 9.62%. The interest on these accounts are compounded semi-annually and the advertised rate is only good for 6 months. Every half-year a new rate is offered that is closely pegged to inflation. Read more here.
- U.S. Savings Bond – If you’re saving for a long term goal such as college, retirement, a house, etc. then savings bonds are a safe place to invest. The rates don’t always keep up with inflation and even CDs tend to have higher yields on average, but they are backed by the U.S. government and deposits can be greater than the typical $250,000 cap by banks and the FDIC.