What’s a Certificate of Deposit (CD)?

A certificate of deposit (CD) is a timed deposit account offered by financial institutions that gives you a higher interest rate.

Certificate of deposit (CD) overview and definition

If you’re looking to earn higher interest rates than what you’re getting in your savings and checking account, you have several options.

Related: Best high-yield savings accounts

You can invest your money in the stock market or open a high-interest deposit account, such as a CD.

When you invest in index funds or individual stocks, you must be willing to take on the risk of losing money. That’s why people will choose to open a CD account.

Since a CD is a deposit account, it isn’t being invested in the stock market. Instead, it’s being held at a financial institution similar to a checking, savings, or money market account.

Related: Savings account vs. money market account

A certificate of deposit (CD) is an account offered by financial institutions that gives you a higher interest rate for holding your funds for a set term.

The term, amount, and interest rate are set when you open the account.

How it works

When you open a CD, you enter an agreement with a financial institution. You’re allowing them to use your money for a fixed term. They use the money to give loans to other customers.

Since you’re allowing the financial institution to use your funds for a time period, they’ll pay you a higher interest rate.

The terms differ by the financial institution. However, it commonly ranges from three months to five years.

Many financial institutions pay the interest that you earn monthly, which is great because it’ll compound every month.

Some have a feature to deposit the interest into your checking or savings account.

During the term, you aren’t supposed to withdraw the funds. If you do, you may be required to pay a penalty.

The end of your term is known as maturity. When your CD matures, you can renew it or close it out.

This is typically decided at account opening. However, most financial institutions give you a grace period after maturity if you selected automatic renewal. This allows you to withdraw the funds if you change your mind.

Different types

With the traditional CD, you make a deposit and allow the financial institution to hold the funds for a term. In return, you get paid a set interest rate, and you can’t make any changes to it.

The traditional CD is the most popular type of CD, but it’s not the only one. The following are the other types of CD’s and how they differ:

• Bump-up CD. If interest rates increase during your term, you can ask your financial institution to raise your rate. Your initial rate may be lower than a traditional CD due to the bump-up feature.
• Add-to CD. You can make additional deposits to your CD after it’s been opened. Typically, it’ll be a set amount that’s done automatically until it matures.
• Jumbo CD. You’ll get a higher interest rate in exchange for a larger minimum deposit. Expect a minimum deposit of $100,000 or more.
• No-penalty CD. It allows you to withdraw funds from your CD without a penalty. This type of CD normally has a lower interest rate.
• IRA CD. A CD that’s specifically for retirement and categorized under your individual retirement account (IRA).

Pros and cons

The following are the benefits and advantages of opening a CD:

• Low-risk. You won’t lose any money because it’s being held by a financial institution instead of being invested in the stock market. You’re also federally insured by the FDIC or NCUA up to $250,000.
• Higher rates. You’ll likely earn a higher interest rate than checking, savings, and money market account.
• A wide selection of terms. Depending on your comfort level, there are many different terms to choose from.
• Predictability. Since you have a set term and interest rate, you’ll know exactly how much interest you’ll earn.

The following are the disadvantages of opening a CD:

• Low returns. Compared to potential earnings by investing in the stock market, CD earnings are low.
• Inflation. Your interest rate may be lower than the rate of inflation.
• Limited access. You commit to allowing the bank to lock your funds, which limits your access. If you want to make a withdrawal, it’s subject to a penalty.

Where to get a CD

Most financial institutions offer CDs. Shop around to find the best rate based on the amount you’re willing to deposit and the term.

Typically, online banks will pay higher rates because they don’t have the overhead of a brick-and-mortar location.

Conclusion

Overall, a CD is a great way to earn more interest if you’re looking for higher rates without investing in the stock market. It can fall short with returns, but it’ll give you peace of mind knowing that you won’t lose any money.

More resources:

• How to earn passive income
• What are the different types of IRAs?
• Why you should join the FIRE movement

Featured image courtesy of Unsplash.