What is a Certificate of Deposit?
- April 21, 2017
- Posted by: Jeff Gitlen
- Category: Banking
A certificate of deposit, better known as a CD, is a type of investment sold by financial institutions such as banks and credit unions. Unlike depositing money into a savings or checking account, use of a CD requires you to commit to either a short- or long-term investment of a fixed number of months or years. For many reasons, a certificate of deposit is considered one of the safest investments to make, but it does tie money up for however long the particular CD lasts. The interest rate on a CD is generally a little higher than what is available from depositing with money market, checking, or savings accounts. The higher interest rate is to compensate the investor for not having use of their money for a predetermined length of time.
Certificates of Deposit come in different terms and different amounts. For instance, some banks may offer CDs with term lengths of anywhere from twelve months to five years, or in some cases even longer. Small Certificates of Deposit are those purchased for less than $100,000, while those of $100,000 or greater are called large CDs or jumbo CDs. Typically, large CDs have more attractive interest rates, which means the investor stands to make a higher return on their money. Since the investor gives up use of more of their money, and foregoes the opportunity to make other investments during that time, financial institutions offer higher compensation.
Although the concept of a Certificates of Deposit is quite simple, there are many versions to choose from. Here are just a few of the various types:
- Traditional Certificate of Deposit – This is the basic CD concept. In return for a fixed interest rate, the investor deposits a certain amount of cash into an account for a fixed duration of time. When that duration is over, the investor can choose to withdraw the deposit (with interest earned) or roll it into a new CD. Early withdrawal of funds will incur early withdrawal penalties.
- Liquid Certificate of Deposit – This type allows the investor to access their cash even during the fixed duration of the CD. These types of CDs offer a lower interest rate than traditional CDs, but the rate is typically still better than investments such as money market accounts or checking and savings accounts. If you choose a liquid CD, pay careful attention to the terms because there are often strict limits on withdrawals and amounts. Withdrawals that don’t abide by the terms can generate penalties that eat up the interest earned.
- Bump-Up Certificate of Deposit – Many financial institutions offer bump-up CDs, which allow an investor to switch to a new, higher (and therefore more lucrative) interest rate if one becomes available mid-CD. The new rate must be offered on a CD of similar duration to the one already invested in. Generally, after the bump-up, the new rate will become effective and remain in effect until the end of the original CD’s term. Many financial institutions offer this type of CD to lure in investors who are otherwise afraid that committing to a CD will cause them to lose out on future, higher interest rates.
Benefits of Using a Certificate of Deposit
A CD is a good idea for someone who wants a very safe investment and doesn’t mind losing access to their money for a few years. With a CD, the rate of return on their money is fixed and guaranteed, which means it is not subject to fluctuations in the financial markets and is guaranteed not to lose money over time the way investing into stocks might. With a CD investment, you will know your money is about as safe as it can be as long as the financial institution is not in distress. Even then, accounts at most banks and credit unions, including CD accounts, are insured by the Federal Deposit Insurance Corporation (also known as the FDIC) for up to $250,000. Always ask if your financial institution is FDIC-insured prior to depositing money.
Some savings situations lend themselves very well to the use of CDs. If you want to save your money for a large purchase, such as a car or a down payment on a home, CDs are a good choice. Your money will be at extremely little risk, you know ahead of time that you do not need to access it for a predetermined amount of time, and it will grow through interest. When it comes time to make the purchase, you will have more in your CD account than you originally deposited, which makes your goal that much easier to reach.
Drawbacks to Using a Certificate of Deposit
The most obvious drawback to using a CD is that the money will remain unavailable for a set period of time. If you do need to access your money, be prepared to pay an early withdrawal penalty. These sorts of penalties can easily eat up the money earned, so far, through interest, which defeats the point of investing into a CD. So, before you decide on a CD, ask yourself a couple of questions.
First, how long do you anticipate not needing this sum of money? Consider other resources available to you that can be used instead of early withdrawal from the CD, such as low interest credit cards for short-term purchases, money in your checking or savings accounts, and an emergency fund. However, some options, such as credit cards, may be so much more expensive that they aren’t any better than incurring early withdrawal penalties from a CD.
Second, are interest rates on the rise or declining? This will help you determine whether you should tie up your money for very long. If interest rates are rising, consider a short-term CD that will allow you to withdraw your money and reinvest with higher rates in the near future. If interest rates are falling, then a long-term CD is a good choice to lock in a higher rate now before it is no longer available.
CDs don't normally offer very high rates of return on your money, objectively speaking. While CDs are considered a very safe investment, they aren’t considered a particularly lucrative one. The stock market, by many expert calculations, delivers a much higher average annual return. Investors who are willing to accept the inherent risk that comes with investing into stocks, even very safe stocks, stand to make more on their money when invested into the stock market than into CDs. And there are also bonds as well as many other investment options.
Another downside to using CDs is the interest earned on a CD is taxable at a higher rate than some other types of investments. The financial institution that offers you the CD will provide you with a 1099-INT statement at the end of each year that states the amount of interest that was earned. This interest is taxed as interest income, not as capital gains (capital gains are taxed at a lower rate). The exception to this is when the CD is used as a retirement savings vehicle, such as when money is deposited into an IRA certificate. In this case, tax deferral rules that apply to these types of retirement accounts will kick in, and no 1099-INT will be issued until years later, when money is withdrawn during retirement.
In short, there are many pros and cons to investing in CDs. They are a safe alternative to the stock market, while paying a higher rate of return on your money than checking, savings, or money market accounts. If you do decide to invest in CDs, shop around for those with the best rates and low early withdrawal penalties—just in case you end up needing your money sooner than you anticipated. And always make sure that the financial institution you choose is FDIC-insured.