Most people understand that it is important to save money in order to meet their financial goals. A certificate of deposit account might help you to build your savings more quickly than a traditional savings account. These time-deposited accounts pay higher interest rates than traditional savings accounts, allowing you to earn more money.
What Is a Certificate of Deposit?
A certificate of deposit is a type of savings account that you can find at banks and credit unions. These accounts pay fixed rates of interest and have defined withdrawal dates. When you open a certificate of deposit account, you agree to leave your money in the account until the called-for date of withdrawal. If you withdraw your money early, you will have to pay a penalty. These accounts typically do not charge monthly fees and pay higher interest rates.
The theory behind certificate of deposit accounts is that you give up the liquidity in exchange for receiving a higher return. Typically, long-term certificates of deposit have higher rates of interest than short-term certificates of deposit. The reason why longer-term CDs pay higher interest is that there is more risk associated with holding on to the CD for a lengthy time period. You are also compensated with higher interest for giving up your ability to use the funds until the maturity date of the account.
The Types of Certificate of Deposit Accounts
There are several different types of certificate of deposit accounts. It is important for you to understand the benefits of each type so that you can make a better-informed decision.
Traditional CD Accounts
Traditional CDs will have varying maturity dates, according to what is offered by your bank. The maturity dates may range from a few months to several years. According to the Wall Street Journal, traditional CDs have fixed interest rates, and the interest may be compounded annually or daily.
Withdrawing your money early will normally subject you to an early withdrawal penalty.
Investopedia reports that jumbo certificate of deposit accounts are CDs for $100,000 or more. Jumbo CDs normally pay higher interest rates than other types of CDs.
Variable Rate CDs
Instead of having a fixed interest rate, a variable rate CD will have an interest rate that varies according to a market index. These can be good if the market rates increase or bad if the market rates fall. Variable rate CDs also often start out at lower interest rates than other types of CDs, meaning that the market rates would need to increase substantially in order to make variable rate CDs a good choice for you.
Step-up CDs start out at an interest rate that is slightly lower than the rates that are offered by traditional CDs. The interest rate steps up automatically at specified intervals during the term of the CD.
CDs in IRAs
Individual retirement accounts may contain many different types of investments, including CDs. IRAs are savings accounts that are tax-advantaged.
CD ladders involve you investing in a series of CDs with different terms. Using this investment strategy allows you to benefit from the higher rates of the longer-term CDs while not having to have all your investment money tied up for the entire time.
Certificate of Deposit vs. Savings Account
CDs are similar to savings accounts in that they offer you a short-term investment vehicle. Both are accounts that pay interest, so you can build your reserves. Savings accounts are held by credit unions or banks and pay very low rates of interest. The number of withdrawals that you can make from a savings account may be limited by the month. Over time, the interest rate that you receive may fluctuate as the Federal Reserve sets interest rates. You may also be required to maintain a minimum balance to keep your savings account open. However, your ability to withdraw money makes these accounts much more liquid than CDs.
To have a CD, you must purchase it by paying a minimum amount. You will also not be able to withdraw your money for a specific period of time. If you make withdrawals before the CD matures, you will have to pay a penalty. CDs pay higher rates of interest than savings accounts. When you purchase a CD, you will be given a certificate that shows your ownership of the account.
Example of Certificate of Deposit
To understand how a CD works, it is important for you to understand the difference between the annual percentage rate and the annual percentage yield. For example, for a $1,000 two-year CD that pays 2.4 percent, the APR refers to the simple interest of 2.4 percent, which would mean that you earn $24 in one year. However, the APR does not include compounding, and most CDs have compounded interest. Imagine that your CD has its interest compounded twice per year. This means that the 2.4 percent is divided in two, so at six months, the first interest payment would be calculated as $1,000 times 1.2 percent, or $12. That $12 would be added to the balance, so you would have $1,012. When the next six months is finished, interest would be calculated by multiplying $1,012 times 1.2 percent, or $1,024.14. At the next six-month point, the $1,024.14 would be multiplied by 1.2 percent to give you a total of $1,036.43. At its date of maturation, the total would be $1,036.43 multiplied by 1.2 percent again, which would give you a total of $1,048.87.
Certificate of deposit accounts are a low-risk way for you to save money. Your deposits are insured by the FDIC for up to $250,000. Since they pay higher interest than traditional savings accounts, they might be good choices to help you build your cash reserves. However, since your investment will not be liquid, you should only invest the funds in a CD that you will not need to have access to prior to the maturity date of the certificate of deposit.