What is a CD?: A Quick 101 Guide
A Bank CD is an acronym for Certificate of Deposit.
Banks and credit unions, both offer depositors or members the option of purchasing CDs which are like savings accounts that you promise not to withdraw money from for a specific period of time.
In exchange for your commitment of 3-36 months, the bank will pay you a higher interest. However, if you withdraw money from the CD before it matures, you may be subject to penalties.
CDs have a significant advantage over other low-risk investments because they are insured by the FDIC for up to $250,000.
FDIC insurance means that even if the bank goes out of business you won't lose your money.
Purchasing a CD
Opening or buying a CD is as simple as visiting the bank, either in person or online. Obtaining a CD is a simple as 1-2-3:
- Choose the CD terms that are right for you
- Read and sign the enrollment agreement
- Transfer or deposit funds to the CD
Other than the type and term of CD, the most important decision you have to make is what you want done with the interest your CD earns. In most cases you have three choices:
- Receive a check
- Have it transferred to your savings or checking account
- Reinvest it
Banks use the term rollover to talk about reinvesting your original investment and earned interest when the CD matures.
For example, if you purchased a $1,000 CD and it earned $20 in interest and you choose to roll it over, you would have a new CD worth $1,020.
You can usually make the decision to rollover your CD at anytime before it reaches maturity.
An advantage of a rollover is that you won't have to complete a another set of paperwork for the new CD.
Even though CDs are not glamorous or exciting investments, they do have some important benefits.
- Safe and Secure – Unlike other investments, CDs are fully insured for up to $250,000.
- Better return – CDs pay a higher interest rate than ordinary savings accounts.
- Flexibility – You can choose from a variety of terms (length of commitment), rollover choices and fixed or variable interest rates.
- Short-term investments – CDs are an ideal place to stash cash for your emergency fund or as part of your retirement plan because CDs are very liquid.
1. Choosing the Right CD
There is no such thing as the best CD for everyone. There are only the best CDs for you and your needs.
Choosing the right CD means matching your goals with the right combination of terms and type of CD.
Goals for your investment
Before you can choose the right certificate of deposit you have to define your goals. Often the best way to do this is by asking yourself questions and two important questions are:
- Do you anticipate needing the money in the short or long-term?
- What is more important interest rate or liquidity?
The length of time a CD takes to mature (earn all of its interest) can be anywhere from three months to three years.
As a rule, the longer the term of the CD, the higher the interest rate it will pay.
The best way to choose the term of a CD that is right for you is to have an idea of how soon you will need access to your money.
This is important because banks will charge you an early withdrawal penalty if you cash out your CD before it matures.
The amount of the penalty is a percentage of the interest the CD is expected to earn.
In some cases, banks will take a portion of your principle (the money you put in) if the CD did not earn enough interest to cover the penalty.
Common types of CDs
Just like CDs come in a range of terms, there are different types of CDs.
These are sometimes called fixed interest CDs because they pay a fixed interest rate over the CD term.
Fixed rate or traditional CDs are by far the most popular type of CD because customers know exactly what to expect.
The interest rate that these CDs earn can change over time, which is what makes them variable.
The interest rates on these CDs are tied to a particular benchmark such as U.S. Treasury Bills.
When the rates on these go up or down, so does the interest rate on the variable CD.
These CDs usually come with a higher minimum purchase amount than other CDs, typically $3,000-$5,000.
They are considered liquid because they allow owners to withdraw a percentage of their investment early without penalty.
Other conditions may include a minimum balance requirement.
In exchange for liquidity, these CDs may offer a lower interest rate than comparable traditional CDs.
Similar to other retirement accounts, the interest earned by these CDs accumulates on a tax deferred basis.
That means that you will not have to pay income taxes on the interest until you retire.
The advantage of this is that your income, and therefore your income tax rate will be lower when you retire saving you money.
These CDs usually prohibit you from withdrawing money until you are 59 ½ years old.
Early withdrawals would be subject to income tax and a 10 percent penalty.
2. What Does It Mean to Ladder a CD?
Why ladder a CD?
Many people like CDs because of their security and higher interest rates.
Some don't like them because they tie up their money for an extended period of time. If you are one of these people, the solution may be CD laddering.
CD laddering balances the benefits of higher interest you receive from a larger and longer term CD, with more access to your money.
CD laddering balances the benefits of higher interest, long-term CDs, with the greater liquidity of short-term, lower interest rate CDs.
Building a CD ladder gives you the best of both worlds by buying multiple longer term CDs with different maturity dates.
Having staggered CD maturity dates enables you to have more regular access to your funds.
CD ladder strategies
A popular way to organize your CDs is by creating a flexible CD ladder that spreads your money across multiple CDs with the goal of having both a regular source of income, while earning the highest interest rate.
For example, if you have $10,000 you wish to invest in CDs and you want to have a regular source of annual income, you would need to buy five $2,000 CDs.
Each of the five CDs would have a term of 1, 2, 3, 4 or 5 years.
When the first CD matures at the end of the first year, you withdraw the interest and rollover the principal into a new five year CD.
By following this process each year at the end of five years, you will have five CDs each earning the maximum interest rate for a 5-year CD.
The same technique can be applied to any amount and any CD term.
3. What to Expect When Your CD Term is Coming to an End
Several weeks before your CD matures, your bank will notify you (usually by U.S. mail) that your CD is about to mature.
The notice will include a description of your options and instructions about what to do once you select one.
When your CD reaches maturity, you have a number of choices:
- Withdraw your principle and interest and renew the CD.
- Withdraw your interest and renew the CD.
- Rollover your principal and interest into a new CD.
- Add funds and purchase a new CD.
- Withdraw the interest and a portion of the principle and buy a smaller CD.
If you choose to cash out some or all of your CD when it matures, you will have the choice of receiving a check in the mail or transferring it to another account.
Whichever option you choose you will have to notify the bank in writing or in-person, as required by your bank.
If you don't follow your bank's rules for notifying them of the changes, they will be ignored.
What happens if you do nothing?
If you forget to respond to the notice or simply choose to do nothing, the bank will hold your money for a grace period of 7-10 days and then it will automatically renew for the same terms as the original CD.
This will result in you being subject to early withdrawal penalties, even if you remember one day after the CD auto renews.