You may have heard the term bank CD and wondered what is a bank CD? A Bank CD (Certificate of Deposit) is a type of savings vehicle offered by banks and credit unions that provide a fixed interest rate at a higher percentage than a regular savings account.
This type of deposit requires the owner to leave a lump-sum untouched for a predetermined period, generally between three months and five years.
Bank CDs are available in almost all financial institutions, with each institution customizing its offer. Overall, the basic features of each deposit are a fixed rate of withdrawal or, as it is commonly known, the maturity date.
What Is A Bank CD And How Do CDs Work?
Bank CDs are somewhat similar to a regular savings account. As long as you have an account at a bank or any financial institution, one you decide to put your money into a CD, you decide on the duration from the options offered by your bank and that’s it.
Your funds will be locked for a set period when you agree to the terms. If you try to withdraw before the predetermined date, you’ll incur a withdrawal penalty, usually in the form of forfeiting the interest earned to date.
There are four main components that make a CD:
Interest rate – The high interest rates are one of the main features of a CD as the rates are generally higher than most other savings accounts and products. The interest rate is also locked in, which provides a clear and predictable return on the deposit over the duration of the CD. The financial institution cannot later change their rates after a CD has been locked in.
The principal – This refers to the amount that you agree to deposit when you open the CD. Depending on the type of CD you encounter, some have higher principal requirements than others. Most CDs can be obtained with as little as $500, depending on the financial institution.
The term – This is the term you agree to leave your funds in the CD. The term ends on a maturity date when your CD has fully matured, and you can then make a withdrawal penalty-free.
The institution – Every financial institution has its rules regarding opening a bank CD. There are rules about Early Withdrawal Penalties (EWP) and whether your funds will be automatically reinvested if you don’t provide any instructions at the time of maturity.
Once you open an account, the financial institution will provide you with electronic or paper statements, either monthly and quarterly. Depending on how the CD is structured, the accumulated interest may be shown monthly or quarterly or it may only be reflected in the balance of the CD once it matures.
CDs are usually federally insured. But CDs from a credit union are insured by the National Credit Union Administration.
Types of CDs
There are a number of different types of CDs, which are not offered by all financial institutions:
- High-yield CD – This CD has an above-average rate. You can find them usually in online-only banks and credit unions.
- Jumbo CD – This CD stands out because it has a high minimum balance requirement. Typically an upward of $100,000.
- No penalty CD – Also known as a liquid CD. This is different from traditional CD as it allows you to withdraw early without a penalty.
- IRA CD – This is an ordinary CD that’s held in tax-advantaged individual retirement accounts.
- Step-up CD – This CD is different from the traditional CD because APYs automatically increase at regular intervals. For example, rates on a 28-month CD may increase every seven months.
- Bump-up CD – This CDs typically have a lower rate compared to fixed-rate CDs, and some of them have a steeper minimum deposit requirement. One of the perks of this CD is that you can get a higher rate if your bank increases its APY.
- Brokered CD – This is a CD that a third party or broker offers.
CDs are also categorized by term and type, for example, 1-year CD rates, 3-year CD rates.
Are CDs Worth It?
Certificate of deposits are a fixed interest rate, safe and federally insured savings vehicle that can provide a higher return than other accounts, such as a regular savings or money market account. They are an excellent option to hold funds for the short term, usually less than a year. Your funds generate a return without taking on the volatility of the stock market.
But before choosing a CD, you need to understand its pros and cons.
Pros And Cons of A Bank CD
One of the main benefits of a CD is that it is a safe investment. There’s no risk that you’ll lose your principal. CDs also have a fixed rate and therefore a predictable return. This is beneficial as you’ll know exactly how much money you’ll earn over the term of the CD, whether it’s months or years. In contrast, financial institutions change rates on regular savings accounts as they wish.
CDs can be an excellent tool for saving up for a future purchase. As a rule of thumb, the longer the term, the higher the interest rate. On the other hand, the shorter the term, the more opportunities you have to withdraw and utilize the funds.
Cons Of A CDs
One of the downsides with a CD is that you lose the flexibility of being able to use your money while it’s in a CD, because it’s locked up for the duration of the CD. Once you put a lump sum of funds, you can’t add or withdraw anything until the term ends, unless you want to forfeit the interest earned to date or incur Early Withdrawal Penalties, depending on the terms of the CD.
The fixed rate can be a blessing or curse, depending on how future rates change. If you have a long duration CD, say 2 or 3yrs and interest rates rise after the first year. You will miss out on the increased interest rate until the CD matures.
CD Vs Opening A Savings Or Money Market Account
CDs are a unique type of savings instrument. Like a savings or money market account, they provide a way of putting aside your money for a specific savings goal, e.g., buying a new vehicle or making a downpayment for a house. The only difference is that savings and money markets allow you to make additional deposits.
Furthermore, you can make several withdrawals per month. As explained with CDs, once the initial deposit is made, you have to leave the amount in the account until it reaches its maturity date, whether it’s months or years. In return for making this sacrifice, your money grows at a higher interest rate, unlike money markets and savings accounts.
How CD Rates Are Set
Generally, the Federal Reserve Board’s rate-setting rules govern how much interest one can earn from deposits. Every six to eight weeks, the Fed’s Federal Open Market Committee (FOMC) decides whether to raise, lower, or leave the rates as they are. This rate represents the interest that banks pay to borrow money through the Federal.
When the Fed fund rates are low, banks have less incentive to hold on to deposits from consumers. But when the Federal fund rate is moderate to high, banks offer competitive rates to encourage consumers to make more deposits.
The government lowered their rates to between 0% and 0.25% in March 2020 to cushion the economy from the impact of COVID. This low rate makes CDs less attractive for cash investors. Aside from the Fed’s decision, the situation of each financial institution determines how much interest they are willing to pay for specific CDs.
For example, if a bank’s lending business is thriving and an increasing amount of deposits is needed to fund those loans, the bank may be more determined to attract more deposits through CDs. Conversely, a large bank with large deposit reserves may be less interested in offering CDs with attractive rates.
When Is A CD The Right Choice?
Although CDs have a history of offering better returns than savings accounts, they may not be the best approach as an investment. But CDs are useful in a number of situations. Maybe you have cash that you don’t want to use right now but will need it in the next year or so to make a down payment for a house or use towards a large purchase. Or, you may want a portion of your funds accessible but don’t want to touch your other stock and bond investments.
Although CDs don’t have the growth potential of equity or debt investments, they are free from the risk of market downturns and losses. If you want your money to grow in value, but don’t want to take any risk, then CDs are a great choice.
CDs can also be a good fit if you’re worried that you won’t have the discipline to avoid tapping into your savings. The fixed-term CD comes with a penalty for early withdrawal. So you can use CDs to build short-term wealth before investing. For instance, you can fix the funds for a 6 months or a year as you plan on how to invest your money.
One way that you can use a CD is to set aside your emergency fund in one. This allows you to ensure that you have the right funds for emergencies because the amount remains untouched. Also, your funds will earn a better return than if you had deposited in a money market or savings account. Just be sure to understand any Early Withdrawal Penalties before choosing this strategy.
Shopping For A CD – Where To Start
You can get a CD from any bank or credit union. So you can start shopping for a CD by checking at your local bank and any other bank or credit union in your community. Alternatively, you can open a CD through your brokerage account. Online-only banks tend to provide higher interest rates on CDs as they have lower overheads due to not having physical branches.
What Happens Once Your CD Matures
Once a CD matures or expires, you are free to withdraw your funds without paying the penalty. At that time, you have three options:
- You can withdraw the proceeds. You can do this either by transferring the funds to an external account or have the institution mail the funds via check.
- Transfer the funds to another account in that bank. For instance, you can transfer the funds to savings, money market, or checking accounts.
- Rollover the CD to another CD in the same bank. You have the choice whether to extend or shorten the term of the new CD, also the interest rate will be whatever the current interest rates are, whether they’ve increased or decreased.
Once your CD matures, your financial institution should reach out to you so that you can alert them to what you would like to do next. But in most instances, the default move is to roll over your proceeds into a new CD. So, should you let the proceeds rollover? Generally, you shouldn’t let your money roll over to another term, unless you don’t have specific plans for the money. Remember that CDs are not a means of building wealth but rather focus on saving. If you want to maximize your returns, you are better off investing.
It also helps to take the time to shop for the best CD rates in the market. Once you’ve done your homework, you could go for the CD that best meets your needs and gives you the best rates. Switching banks or credit unions should always be considered.
CD Strategies That You Should Leverage
You must harness strategies that will boost your CD’s performance. One of the strategies is a CD ladder. It entails dividing up your investment into several CDs with varying term lengths. When each CD matures, you can put that money into a long-term CD, so that you can reap good proceeds from potentially higher rates over time.
The second strategy is called a CD bullet strategy. This consists of one or multiple CDs with similar maturity dates. This approach aims to build savings for a big purchase in the not-too-distant future, e.g., A down payment for a home.
The third strategy is known as a CD barbell. It entails splitting your investment into long-term and short-term CDs as you wait for higher rates before putting your funds in a long-term account.
These strategies help you lower your risk of missing out should better rates appear at a later date.
What If You Want To Withdraw Your Funds Early?
Life is uncertain, and even when you set your funds for a fixed date, something can happen, and you need the funds. Putting your funds in a CD doesn’t mean that you can’t withdraw these funds. All financial institutions have stipulations on how you can withdraw the funds early.
Of course, such a withdrawal comes at a penalty. In most instances, financial institutions permit premature termination by assessing the early withdrawal penalty (EWP) on the proceeds before giving you the funds. This means that you need to know what the terms are before you open the account. Typically, the EWP is charged on the number of month’s interest. For instance, a bank’s policy may be to deduct three months’ worth of interest from a CD with a 12-month term as a penalty for early withdrawal.
You need to learn about the institution’s withdrawal policy before opening the account to avoid incurring penalties that would eat into your deposit.
The Bottom Line
Most savers prefer certificates of deposits because they are safe and offer a higher rate than traditional savings. But, you should not use a CD as an investment strategy. This is because CDs provide a modest return that’s not enough to build wealth. If you want to reap a good yield, then you’re better off investing the funds in the stock market. Lastly, remember to shop around for CDs with the best rates and understand the institution’s guidelines before depositing your funds.
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