What Is a Certificate of Deposit (CD)?

A certificate of deposit (CD) is a savings certificate with a fixed maturity date and specified fixed interest rate that can be issued in any denomination aside from minimum investment requirements. A CD restricts access to the funds until the maturity date of the investment. CDs are generally issued by commercial banks and are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per individual.

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Certificate of Deposit (CD)

Understanding Certificates of Deposit

A certificate of deposit (CD) is a promissory note issued by a bank. It is a time deposit that restricts holders from withdrawing funds on demand. A CD is typically issued electronically and may automatically renew upon the maturity of the original CD. When the CD matures, the entire amount of principal, as well as interest earned, is available for withdrawal. CDs typically do not have a fee unless withdrawn before the maturity date. Most CDs offer higher interest rates than those available from savings and money market accounts.

It is also important to understand the difference between the annual percentage yield (APY) and the annual percentage rate (APR). APY is the interest a CD actually earns in one year, factoring in compounding. APR is the stated annual interest rate, disregarding compounding.

The Theory Behind CDs

CDs operate under the premise that you forfeit liquidity for a higher return. Under typical market conditions, long-term CDs have higher interest rates when compared to short-term CDs. There are more uncertainty and risk associated with holding the investment for a long period of time. In addition, because you are forgoing the opportunity to use the funds for a specific period, you are compensated by earning more interest. 

CDs vs. Savings Accounts

Savings accounts offer instant access to funds, whereas CDs typically restrict access. Both CDs and savings accounts are insured by the FDIC or National Credit Union Administration (NCUA) for share certificates purchased at a credit union up to a limit of $250,000 per individual. The insurance does not cover early withdrawal penalties for cashing in a CD before maturity. 

Safety of CDs

Although CDs do not provide a high return, especially compared to investing the same amount in the stock market, investing in CDs is considered relatively safe. The funds are insured, and, assuming there are no early withdrawal penalties, the investment is considered to be as safe as cash in a savings or checking account. Rates vary, but they are generally near the current rate of inflation.

Early Withdrawal Penalty

In most cases, it is possible to withdraw money from a CD before the maturity date, although this action will often incur a penalty. This penalty is referred to as an early withdrawal penalty, and the total dollar amount depends on the length of the CD, as well as the issuing institution. Typical early withdrawal penalties are equal to an established amount of interest. 

Negotiable vs. Non-Negotiable

Most CDs are non-negotiable, meaning they can’t be transferred, sold, bought, or exchanged. In most cases, non-negotiable CDs can be cashed in before maturity by paying an early withdrawal penalty. Negotiable CDs, also known as NCDs, are just the opposite. They can be sold in the secondary market but can’t be cashed in before they mature. With few exceptions, NCDs are issued in large denominations of $100,000 or more. Another feature of NCDs is that they are short term and have maturity dates of between two weeks and one year. 

Small vs. Large CDs

CDs of less than $100,000 are called small CDs. Some of these CDs will have minimum investment requirements. For example, a financial institution may require at least $1,000 for a CD to be opened. CDs for more than $100,000 are called large CDs or jumbo CDs. Almost all large CDs, as well as some small CDs, are negotiable. The term of a CD generally ranges from one month to five years. 

Specialty CDs

Most CDs come with a fixed term and a fixed rate of return. Beyond terms such as small, large, non-negotiable, and negotiable, there are several varieties from which you can choose.

  • Liquid CDs. These feature low or no penalty for early withdrawal, overcoming one of the main objections people have about CDs. This feature comes at a cost, including a lower rate of return, and, in many cases, a minimum balance requirement. Even with those caveats, in a fluctuating interest environment, liquid CDs enable you to move your funds to a higher-paying certificate when the opportunity presents itself. 
  • Bump-Up CDs. Like liquid CDs, these have a lower interest rate than fixed-rate CDs but let you take advantage of a new higher interest rate and apply that rate to your existing CD. As with liquid CDs, bump-up CDs may also require a high minimum deposit. Bump-up CDs also typically limit the number of times a higher rate can be activated, depending on the length of the term. 
  • Step-Up CDs. These are often confused with bump-up certificates, although they are not the same. Unlike bump-up CDs, which allow you to take advantage of a higher rate, step-up CDs raise rates at regular intervals on a preset basis. It’s important to know what the overall (blended) interest rate is and compare that with a regular CD of the same term length. 
  • IRA CDs. These are regular CDs held in a tax-advantaged individual retirement account (IRA). As CDs offer relatively low interest rates compared to other investments, taking up a significant part of your annual IRA contribution limit with CDs could lead to much-lower-than-expected returns in your IRA retirement account. 
  • Brokered CDs. These are sold through brokerage accounts and sometimes offer better rates than those sold through a bank or credit union. It’s important to make sure the brokered CD is FDIC insured or offers a high enough interest rate to outweigh the risk when it isn’t insured. It’s also worth noting that brokered CDs can be difficult to get out of when you want to exit the investment. 

Benefits of a CD

As CDs typically pay higher interest than savings accounts but offer lower returns than stocks, they are a good option for those who don’t need access to the cash for a set period and want to minimize risk. A five-year CD with a 3.15% annual percentage yield (APY) compounded monthly will earn $4,258.48 on a $25,000 initial deposit.

The same amount of money kept in a savings account that pays 2.25% would earn just $2,973.86, assuming the interest rate stays the same, something that is not guaranteed with a savings account. Online banks tend to have the most competitive rates for both CDs and savings accounts. 

Compounding involves interest accumulating interest. Interest paid more than once per year yields the sum of the interest from each payment. For example, Patrick buys a one-year, $5,000 CD that pays 6% semiannually, she will receive an interest payment of $150 after the first six months ($5,000 x 6% x .5 year). In addition to the principle, the $150 interest earns interest. Because of compounding, the interest earns $4.50 over the next six months ($150 x 6% x .5 year). As a result, the yield is actually 6.09%. The .09% may seem insignificant, but, over time, it can produce significant results.

Picking a CD Maturity Term

Typical CD term lengths range from three months to five years. As noted above, in most cases, the longer the terms, the higher the interest rate. All things being equal, a longer-term CD is better, because it provides the best interest rate. There are exceptions to consider, including whether you may need the funds for an emergency and whether current interest rates are on the rise, making it less attractive to lock in what might end up being a low rate for a long time.

Early withdrawal penalties can eat into the return and, in some cases, into principal. While it’s impossible to predict CD rates into the future, the graph below shows just how volatile national average rates can be for terms of one, two, three, four and five years from a historical perspective.

If you think interest rates will be going down soon, a five-year term CD might make sense. If you believe rates will go up, shorter-term one-year (or less) CDs may be a smart move. 

Using a CD Ladder

One way to overcome the disadvantage of the interest rate trade-off between short-term and long-term CDs and hedge against fluctuating rates is to use what’s known as a CD ladder, a strategy that involves dividing the amount to be invested among several CDs with different term lengths (e.g., one, two, three, four, and five years).

This strategy makes a portion of the investment available at regular intervals. As each CD matures, the funds are re-invested in a five-year CD at the then highest prevailing rate. Eventually, you have a portfolio of recurring five-year CDs, each maturing on an annual basis. 

How a CD Ladder Works

As the table below demonstrates, depending on goals and liquidity needs, a CD ladder offers a compromise between short-term and long-term CDs. Assuming an initial investment of $10,000, laddering or splitting the $10,000 into five CDs of $2,000 each at varying interest rates for terms ranging from one to five years and reinvesting into a five-year CD as each matures results in $11,590.59 at the end of five years, with access to at least $2,000 annually. That’s $146.96 more than the $11,443.63 realized by investing the full $10,000 in a one-year CD, paying 2.70% and renewing that CD annually.

Investing in a five-year CD at 3.10%, held for the full five years, totals $11,674.25 at the end of year five with no access to the money for the full five years. All examples below assume stable interest rates for the entire five years.


Buy Today



End of Year One



End of Year Two



End of Year Three



End of Year Four



End of Year Five



One-Year CD @2.60%


$2,000



$2,052.62


Buy 5 Yr. CD @3.10%



$2,117.16 @3.10%


 



$2,183.74 @3.10%



$2,252.40 @3.10%



$2,323.23 @3.10%



Two-Year CD @2.75%


$2,000



$2,055.70



$2,112.95


Buy Five-Year CD @3.10%



$2,179.39



$2,247.92



$2,318.60



Three- Year CD @2.75%


$2,000



$2,055.70



$2,112.95



$2,171.79


Buy Five-Year CD @3.10%



$2,240.08



$2,310.52



Four-Year CD @2.76%


$2,000



$2,055.90



$2,113.37



$2,172.44



$2,233.17


Buy Five-Year CD @3.10%



$2,303.39



Five-Year CD @3.10%


$2,000



$2,062.89



$2,127.75



$2,194.66



$2,263.67



$2,334.85


Buy Five-Year CD @3.10%



Ladder CD Total


$10,000



$10,282.81



$10,584.18



$10,902.02



$11,237.24



$11,590.59



One-Year CD @2.70%


$10,000



$10,273.37



$10,554.21



$10,842.72



$11,139.13



$11,443.63



Five-Year CD @3.10%


$10,000



$10,314.44



$10,638.77



$10,973.30



$11,318.35



$11,674.25


Rates from Bankrate as of 11/4/18. Interest compounded monthly. 

How to Buy CDs

Certificates of deposit are sold by banks, credit unions, and some brokerage houses. The best rates are often available online. An online search will reveal the best rates currently available.

Bankrate has a tool that is updated daily and shows some of the best rates available nationally and by local zip code. While interest rates and terms are important, so are early withdrawal penalties, minimum required deposits, and the availability of specialty CDs that might be appropriate. In addition to an online search, a check of local newspaper ads may reveal rates, including “specials” that may not be listed online.