Photo: Image courtesy of Murfie
When it comes to saving money, there are a few banking tools most depositors are familiar with — most savers own at least one savings account, and some may have even opened a money market account.However, another great savings account many people don’t know much about is the certificate of deposit (or CD for short).
If you are currently searching for new ways to grow your money, a certificate of deposit may get you to your savings goals faster. But before opening an account, learn more about the lesser-known features of this type of account.
What Is a Certificate of Deposit?
A certificate of deposit, also known as a CD, is a type of product offered by banks and credit unions that serves a similar function as a savings account. It allows you to deposit money in with a financial institution and earn interest.
The difference, however, between a CD and traditional savings account is that CDs require you to leave your money in the account — untouched — for a predetermined amount of time.
CD rates are usually fixed for the entire term, which means the interest rate offered when you open the account remains the same until the account matures. Account terms can last anywhere from 30 days to five years or more, depending on the financial institution’s options. Generally, the longer the CD term, the higher the interest rate.
It’s important to know that banks and credit unions want to ensure you don’t touch your deposit until the CD matures, so withdrawing money early will almost always result in a significant penalty.
In order to open a CD, you usually have to contribute a minimum opening deposit. This amount can range from $50, to $100,000 for jumbo CDs, but is typically around $500 to $1,000. Pay close attention to minimum deposit amounts since banks sometimes provide higher interest rates for bigger deposits.
5 Things You Might Not Know about CDs
Now that you know a few basics of CD accounts, here are some aspects of these accounts that make them unique. It’s important to keep these in mind as you decide whether a certificate of deposit is right for you.
1. There are several types of CDs.
There are numerous ways to invest in CDs. You can place your money in a traditional account, which allows you to deposit a fixed amount of money for a specific term and receive a predetermined interest rate.
A bump-up CD allows you to take advantage of a higher interest rate midway through your CD term. These CDs typically come with a lower starting rate.
Liquid CDs allow customers to withdraw funds without incurring a penalty, but may require that you maintain a minimum balance to keep acquire that privilege.
Callable CDs allow banks to take back the interest rate they originally offered and provide a lower one instead. Typically, these accounts pay higher starting interest as a reward for taking on the risk of having your CD called back.
2. CDs can automatically renew.
Many financial institutions will automatically roll your CD deposit into a new account when it matures if you don’t advise otherwise. A CD rollover can be a good thing, but not in every case.
If you don’t need access to your money and interest rates have remained the same (or have gone up), an automatic renewal of your certificate of deposit is convenient and allows you to keep earning interest without visiting the bank to open a new account. However, if you do need that money, or interest rates have dropped at that particular bank, allowing your CD to rollover means you’re stuck with a long-term deposit at a lower rate until the account matures again.
You will find out whether or not your CD account automatically renews when you open it, as well as the grace period for letting your bank know whether or not you actually want the funds to rollover.
3. It’s possible to invest in long-term CDs without losing liquidity.
CD laddering is an investment strategy used by individuals who are interested in acquiring several long-term CDs (one to five years) but want to avoid losing access to all their money for several years.
Laddering involves spreading your money across CDs at various terms (6-month, 1-year, 18-month, 2-year, etc.) so that you can always have funds available every six months to one year, while still earning higher interest rates on longer-term accounts.
Note that some are discouraging against laddering now with interest rates projected to be lower than usual for the next few years, so be sure to do your research before using this as one of your investment options.
4. You can invest in CDs within your retirement account.
As with many types of interest, the interest earned on CDs is taxable as income. Investors can sidestep the tax by including CD funds in a 401(k) or IRA. Interest earned in a retirement account isn’t taxed until it’s withdrawn. If you choose to invest in a Roth IRA instead, your initial deposit will be taxed and the interest earned over time will be tax-exempt upon withdrawal.
One the other hand, if you want to move your funds out of an IRA and into a CD, your bank will allow you to do so. However, note that you have 60 days to roll your funds over into a CD. Also, if you are younger than 59 ½, you will pay a 10-per cent penalty for receiving an early distribution.
5. IRA CDs are the same as traditional CDs.
Banks often market IRA CDs that are slightly different than traditional CDs. They don’t require you to roll funds from an IRA to a CD or vice versa. Instead, you can simply open an account, fund the account with a personal bank account (or existing IRA if you choose) and begin earning interest as you would a traditional CD.
Sometimes, banks will offer more attractive rates for IRA CDs and require no minimum deposits to lure in customers, but in most cases, they offer the same terms, penalties, etc. as the traditional CD.
Is Investing in CDs for Me?
Certificates of deposit can help you earn higher interest rates, but the terms and restrictions aren’t for everyone. Here are a few questions to ask yourself when deciding to invest in CDs:
• Can I set money aside and not touch it? Since most financial institutions penalise CD account holders who make early withdrawals, if you think you might need to access your money within the deposit period, you may want to consider a more liquid account.
• Do I already have emergency funds? If you are using the CD as a way to grow money, but don’t have any other funds set aside for emergencies, the penalties that you suffer from withdrawing your funds early could make your investment pointless.
• Do I need portfolio stability? If you have money placed in riskier investment options and need to add security to your portfolio, the CD may be a good option for you.
• Can you handle loss on inflation? If you invest in a long-term CD, it’s possible that the rate of inflation will be higher than the interest rate on your CD and the result could be you losing purchasing power on your invested funds.
One consistency among CD accounts is they almost always offer better rates than traditional savings accounts, which is a definite perk. CD accounts are also federally insured by the FDIC up to $250,000 per depositor. The best way to determine whether a CD is right for you is to educate yourself about how they work, then shop extensively for the best rate before handing your money over to a financial institution.