When it comes to exploring different saving options, we are sure you must have come across CDs. Most often, individuals wonder what is a certificate of deposit. Certificate of Deposits can be referred to as a type of savings account with a fixed term and stable interest rates. Though, you can expect higher rates with CDs compared to the interest rates offered in savings accounts.
A CD account is a savings financial product to earns interest on a lump sum amount that you deposited for a fixed tenure. There is a significant distinct feature between regular savings and certificate of deposits. Money deposited in CDs must remain as it is or untouched till the time of its maturity. If you opt to withdraw money early then you will have to pay penalty fees or face the consequences of lost interest.
While CDs are beneficial with high yield rates, secured money, and more there are certain factors. You must be aware of before you invest your money in any financial institution in certificate of deposits. Don't worry, this guide is dedicated to giving you a roadmap on what a certificate of deposit is. What is CD investment? What are CD rates? And how does it work?
Let us walk you through vital factors on CDs and solve your concerns like what is a CD account. And why should I invest my money in a CD account?
- What is a Certificate of Deposit?
- Savings Account vs Certificate of Deposits
- Key Terminologies to Understand What is a CD account?
- How Do CDs Work?
- Are CDs a safe option?
- What is CD rates? How is it determined?
- Reasons to opt for a Certificate of Deposit
- Pros and cons of CDs
- How are CDs' Interest Earnings Taxed?
- Navigating CD Ladder
- CD Account options after maturity
- What is the CDs Investment Type?
- Bottom Line
- Frequently Asked Questions
What is a Certificate of Deposit?
In simpler words, a certificate of deposits falls under the category of a savings account that has a fixed interest rate, which is higher than a regular savings account. Additionally, Cds have a fixed end date which is termed a maturity date, and fixed term length. When you deposit your money in CD you lock your money for a term ranging from 6 months to 5 years, and you are not allowed to add your contributions amid this tenure. And, CDs do not have any monthly fees but it includes a penalty fee if you withdraw your money before the end date.
Like a regular savings account, even certificates of deposits are federally insured by FDIC so even if your bank or financial institution goes bankrupt your money stays protected. A share certificate is a term used for CDs at Credit Unions. And, CDs at Credit Union are insured by the National Credit Union Administration.
Initially, certificates of deposit were used as paperwork showcasing proof that your money is being held at a bank for a specific interest rate. Though today CDs are not mentioned on any paper document it is still held and insured by up to $250,000 per account and owned at banks by FDIC.
Key elements of Certificate of Deposits:
- The CD is a form of savings account with a safe investment option and fixed interest rate and length term.
- If you want to protect your saved money at a high-interest rate and lesser risk factors then CDs are the optimum option for you.
- While CDs have higher yield rates than savings accounts, you won’t have access to your deposited money until its maturity
Savings Account vs Certificate of Deposits
As we mentioned above CDs are a form of savings account, yet there are few differences between traditional savings accounts offered at banks vs certificates of deposits.
Certificate of Deposits offers exciting higher interest rates than Savings Accounts
CDs tend to have higher interest rates in exchange for no access to your deposits. The amazing combination of higher interest rates and low risk attracts more customers compared to other bank accounts. When you have good lump sum money saved and want to secure it with good interest rates or achieve long-term financial goals, then CDs are your ideal option.
Once you open CDs account, rates stay fixed for the entire term
CDs interest rates are not just higher but also stay fixed throughout the term, unlike regular savings. This can serve as a huge advantage for you especially if you open a CD account when the interest rates are high in the market. You can enjoy the perks with this rate even when the bank drops its rates on new CDs or savings accounts as CD rates stay fixed.
CDs do not give regular money access, while savings account does
In a savings account, you can deposit and withdraw money anytime freely, but with CDs, you can only withdraw your money penalty-free during the short period after the maturity of your account.
Key Terminologies to Understand What is a CD account?
Opening a certificate of deposit is similar to opening other bank deposit accounts. The difference lies in the terms you agree to sign in. When you explore, and analyze different bank’s CD offerings, when you open your CD account with an ideal bank you will deal with 4 elements. We are listing a few terminologies to help you understand what is a certificate of deposit.
Interest rates indicate the predictable return on deposit over time that you locked while opening the account. The bank cannot change the rates later on which may reduce your potential for earning if the rates rise over time and you may lose the chance of benefiting from a high-paying CD interest rate. However, it is advised to analyze, shop and understand the interest rate so that you maximize your earning opportunity.
The term refers to the length of time you agree to deposit your funds for a specific tenure with CDs account. For instance, the term may range from 6 months to 5 years. When the term ends, it is known as maturity date and then you can successfully withdraw your money with a penalty-free.
Principal refers to the total amount of money you agree to deposit in a bank when you open a CD account, though there are few exceptional cases about the principal of CDs.
The type of institution whether it is a bank or Credit Union will determine the terms and factors for the account that you agree to while opening a CDs account. It can include a penalty on early withdrawal, automatic reinvestment after CD maturity if the customer fails to provide any further information or instruction to the institution, and more.
How Do CDs Work?
The process of opening certificates of deposits is similar to the bank account procedure. You can begin by applying online or in person at your ideal bank. The distinctive factor in the certificate of deposits is the initial deposit is the only payment you need to make. Though, you can't add additional contributions over time to the account as you do in a savings account.
The coumpond interest that you earn in CDs are added and credited directly to your account monthly, quarterly, or daily. You will receive interest for the entire principal at the end of the maturity. Or else you can ask for receiving daily interest payments if banks offer such services.
And, once your CDs account ends your bank will renew your CD at a new rate, which matches the rate of new CDs for similar or different terms. Though this may not be the ideal option for you, it is always better the offerings and interest rates of CDs offered in different banks every time you think of opening a new CDs account.
Are CDs a safe option?
Compared to other bank accounts, Certificates of Deposit are one of the best saving or investment options ideally for 2 main reasons:
1. Since the interest rate of CDs is fixed and has minimal to no risk, which guarantees return and there is a very low chance of rates getting fluctuated. In the end, what you agree on in terms of CDs is what you will receive in terms of return. Make sure you research and read thoroughly the agreement and other factors while signing in to the new CDs account.
2. CDs accounts are secured by the same federal insurance as other deposit accounts in the bank - FDIC. The Federal Deposits Insurance Corporation insures money and assets for banks and National Credit Union Administration insures Credit Union.
When you open a CD account with a financial institution insured with FDIC or NCUA, you will get coverage up to $250,00 Even if your institution goes through bankruptcy.
How can I know my CD account is secured?
The first is to select a financial institution that is insured and protected by FDIC or NCUA. While most US banks are insured but there are a few private institutions that aren’t insured by these agencies so don't risk coordinating with these institutions.
If you exceed the deposit of coverage limit protected by FDIC i.e. $250,000 then consider spreading your money across different institutions of the same insurance or manage your deposits with different ownership categories.
What is CD rates? How is it determined?
Any individual who follows interest rates trends or business trends will know that the Federal Reserve's rate-settling system determines what bank customers expect from their earnings on the interest rate. If you are a newbie, you must be wondering what is CD rates. It is the term referred to indicate the interest of tarte offerings when you open your CD account.
The decision on interest rates made by the Federal Reserve can directly affect a bank's cost. Why? Every 6-8 weeks the Federal Open Market Committee decides on whether to change or lower, raise or keep it the same as federal fund rates. And the rates will represent the interest rates that banks will pay to borrow or lend over their excess reserves.
Additionally, federal funds influence the prime rate or the interest rate that the bank would charge to their top creditworthy customers. The prime rate is calculated as def fund rates + 3% points. Also, rates for CDs, savings accounts, and loans are determined by the prime rate. Remember, the higher the prime rate, the high interest you can expect from your CD account.
Reasons to opt for a Certificate of Deposit
When you compare different bank accounts and contemplate what is a certificate of deposit? Every American citizen needs to understand when is the right time or purpose to open a CD account. To give you clarity on the perks of this account, we are discussing a few reasons why you should open your CD account shortly.
When you wish to safeguard your lump sum savings
If you have money kept aside for a long-term financial goal that requires a large purchase like buying a car or saving for a down payment for your first home. A certificate of deposit can be an ideal source of investment to secure your money and let it earn a significant amount of interest over time.
You expect good returns with lesser risk
Investing in CDs can be beneficial only when you want to ignore the volatility of the stock market risks and earn exciting returns that are better than traditional savings accounts. The average rate for savings accounts in the USA is 0.42% which is very low compared to the average rate for a 5-year term CDs account rate which is 1.37% annually as per FDIC.
Another option is you can opt for a high-interest rate with a short term ranging from 3 months to 1 year. This can help you earn better funds rather than waiting to access your funds for years.
Pros and cons of CDs
|Pros for CDs Account
|Cons for CDs Account
|You are subject to penalty fees if you withdraw your money early i.e. before the term end
|You will earn less than the earnings from stocks and bonds over time.
|CDs offer high-interest rates than savings account or even money market accounts
|You will lose the opportunity of earning more return if the interest rate rises amid your term
|CDs accounts are federally insured and protected if you open accounts in FDIC or NCUA financial institutions
|Inflation can affect the value of the money that you deposited with a fixed rate at your bank
|It can help you get rid off overspending as early withdrawals will charge your penalty fees
|You are subject to penalty fees if you withdraw your money early i.e. before the term ends
How are CDs' Interest Earnings Taxed?
After comprehending what is CD rates, you are probably wondering about tax implications on the earnings acquired from CD's account. Let’s understand the taxation regulations in detail. The bank will apply interest to your account on a regular interval. This can be done either monthly or quarterly, and it will be mentioned in your statement as earnings obtained from interest rates of CDs.
It works exactly like interest paid on savings or money market accounts. It will be directly reported in the new financial year as interest earned so you can report the interest earned under your income when you file your tax return.
While many people get confused about CD accounts earnings as they are not withdrawing money. And mistaken by thinking that earnings will be taxed when they withdraw money at the maturity date. That’s not true! In concern to taxation, the tax will be implied on your earnings when your bank applies to your account and not when you withdraw your money.
Navigating CD Ladder
When you explore what is a certificate of deposit? You will come across CD Ladder. It is a type of savings strategy that can involve opening short and long-term CD accounts. This methodology can offer you more flexibility, than depositing all your saved money into one Cd account. You can grow your money with high-interest rates for 3-5 years and still can have regular access to your money.
Sounds confusing? By putting money in different accounts, you invest proportionally by a variety of different terms. As each short-term CD account matures you can reinvest the money in a long-term account with a higher interest rate. Meanwhile, you get to access your money if in case your financial goals change without paying penalty.
Example of Ladder Strategy
You have collected $10,000 for CDs account, you will invest $2000 in 1-2-3-4 years of CDs. When the 1 year matures, you invest more in a long-term CD account. Next, you can reinvest the money received from a 2-year term CD account. Also you can repeat this step until you have a 5-year CD maturing each year. Or else you can choose to withdraw the money from any term if you need urgent cash.
CD Account options after maturity
A month or two from your maturity date your bank will notify you. Also, they will instruct you on the procedure of how you want to proceed with your principal amount. Usually, banks will offer you 3 options:
Transfer total funds to other institutions
Other bank account options can include savings, checking, or money market accounts.
Roll over CD amount to new CDs account
You can opt to roll over your money acquired from the previous CD account to the new CD account. For instance, if you have a 15-month term ending then you can roll over your balance to another 1-year term with a new CD account.
Withdraw your total amount
CDs principal can be withdrawn to another bank account or can be mailed to you as a form of paper check.
What is the CDs Investment Type?
Are you ready to secure your savings in a CD account? Wait, are you still confused about what is CD's investment type? Don't worry, we have answers for you. The interest rate and other perks will differ on the type of investment you have opted for with CDs accounts. Let’s have a detailed understanding of the same.
No penalty CDs
Allows you to withdraw before maturity without an early withdrawal penalty, though you will receive lower interest rates comparatively.
Online and Credit Union banks offer more than average interest rates compared to brick-and-mortar banks
This falls under a regular CDs account which is held in a tax advantage account for retirement funds.
The CD's yield rates are offered to third parties like individual brokers or brokerage firms.
This is similar to a regular CD account but has a high requirement - $100,000 as a trade-off to obtain higher rates.
Step up works on fixed rate interest and some institutions would have a stepper minimum requirement for deposits. In some cases, customers can request an increase in interest rate amid the term, though it is allowed only once.
Certificate of Deposits is a safe, secured, and stable savings and investment option. While interest rates are higher than savings accounts, you must research and know the market trends to maximize your earnings from CDs.
By opting for the right CD type, utilizing the correct ladder strategy, and avoiding withdrawal penalties you can focus on earning a maximum return from CDs easily, safely, and with lesser risk.
Frequently Asked Questions
Yes, especially with online banks and Credit Unions, the interest rates are rising. Before committing your time and saving money to an institution, check out current CD rate trends to maximize your earnings and other benefits.
If you want to withdraw money before the term end date, then you will need to pay penalty fees. This fees will consume a few months to 1 year of interest rates. So it is recommended to avoid early withdrawals until it is of utmost importance.