How Does a CD Account Work?

Written By Cathy Lovering
Last updated May 21, 2021

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Investing
May 21, 2021

Simple. Thrifty. Living.

The best investment portfolios are those that spread out risk. As most investors know, with risk comes reward — but risk can also lead to cash loss from unstable investments.

CD stands for certificate of deposit. It is an arrangement between you and your bank, credit union or other financial institution. You put down a specific amount as principal for a set period at a set interest rate. At the end of that term, you get back your principal plus the interest. You can take it out as cash, or it over may roll over into a new CD.

Because most are FDIC-insured (or NCUA-insured through a credit union), CDs are typically safe investments. They offer several advantages that make them a good component of a diverse investment portfolio designed to manage risk:

  • There is usually a guarantee on principal
  • Interest rate is higher than that of a savings account
  • Funds are “locked in,” which may prevent impulse spending
  • CDs offer varying levels of liquidity, but you can typically withdraw your money before the term ends (with penalty)

A CD is a no-surprises investment. Because the details of the interest rate, term and principal are upfront, you can deposit your funds with confidence. Your investment isn’t subject to the wild swings of the market. And an insured CD means that you also don’t have to worry about losing your money if your bank fails.

As beneficial as a CD is, it’s important to review the drawbacks before investing. This way, you can make sound choices with your money.

There are a few downsides to choosing a CD over other investment instruments:

Set principal amount. You cannot add more funds into an established CD. If you want more money in this type of investment, you must open up a second CD. Having several CDs can be an investment strategy, as it lets you take advantage of different maturity dates. But it also requires coming up with the minimum amount of funds for each CD.

However, the minimum amount depends on where you get your CD. American Express’ CD, for example, is a no-minimum balance, no-fee option.

Early withdrawal penalties. Because your bank is expecting to keep your money for the full term of the CD, it will charge a penalty if you take the money out early. Usually, you only lose some of the interest. But in some cases, the bank may deduct from the principal amount as well.

Static interest rate. Your guaranteed interest rate, or annual percentage yield (APY) is a good thing. But it also locks you in at that rate — even if interest rates rise during the term.

Low interest rate. In return for safety, banks offer a relatively low interest rate. A CD should earn more than a savings account. But it can also earn less than stocks and bonds, which is why a diversified portfolio typically also includes these as well as index funds.

That low interest rate on your CD account might not keep up with inflation. You will have more money than you started with at the end of the term, but that cash may have less buying power than it did when you first invested.

CDs are one of the safest and most practical alternatives to a savings account. But they are less lucrative than other investments like stocks and index funds — although those come with substantially more risk.

A CD is a secure instrument if you are saving toward a specific goal. Instead of putting the funds in a savings account, you can opt for a CD to make a bit more interest. The money also stays out of reach, so you can stay on track with your goals. Some reasons to choose a CD are:

  • As an alternative to cash in an investment portfolio
  • To save for a large purchase, like a down payment on a home
  • As a nest egg for loved ones, children or others you want to support with safe cash

You can also open a CD for no reason at all. It’s a quick way to set money aside when you have a little extra and aren’t yet sure how to use it.

Since there are many CDs out there. It’s worth it to take some time to choose the right one. Look at these factors in particular:

Minimum deposit. Some CDs have no minimum principal amount. Others insist you put down a minimum amount. A higher initial deposit can sometimes give you access to CDs with higher rates of return.

Interest rate or annual percentage yield (APY). This is the amount you will make on your principal. Look closely at how the bank calculates this.

It could compound daily, but the APY compounds over one year. So if your CD term is for less than one year, you will get less than if you just calculated the APY against your principal.

Term of deposit. This is the length of time the CD locks in your funds. If you leave the money in the CD for the full term, you will receive your full interest. If you withdraw it early, you will get less back.

Terms vary widely — although six, 12 or 18 months are typical timeframes, you can also get much shorter terms. Citi Bank’s CDs offer terms of three, four and five months. Citibank also offers terms of three, four and five years, among others.

Opening a few CDs with varying terms can be part of a CD ladder strategy, in which you open CDs of short terms. Then, as they mature, you put them (and the interest they have earned) into long-term CDs at higher rates.

A CD account is a safe way to earn money on your cash. It can help you build a nest egg with little to no risk. Even though they’re known for their security benefits, CDs are far from boring. You can get creative by having CDs for different goals or developing a CD ladder strategy to maximize your returns.

About the Author

Cathy Lovering

Catherine Lovering has written about personal finance and health for over 10 years, with bylines on IvyExec.com and Healthline.com. She holds an LL.B. (J.D.) from the University of Victoria.

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