What are Certificates of Deposit and How Do They Work? For many, a traditional savings account is perceived as the only safe method of saving money. Financial institutions, like banks or credit unions, typically pay a small amount of interest to the account holder in exchange for the use of their money. However, this interest rate is typically under one percent, making it hard for a saver’s money to grow over time. Luckily, there are alternatives. What is a Certificate of Deposit? A Certificate of Deposit (CD) provides the stability of a traditional savings account with a growth rate that looks more like a stock index or bond. A CD is a savings product that earns a fixed rate of interest over a fixed period of time. The account is funded with a lump sum deposit and generates interest off the deposit amount. Unlike a traditional savings account, the deposit cannot be added to or withdrawn without penalty for the CD term. A depositor that opens a CD account will earn a higher interest rate than a conventional savings account in exchange for reduced access to their money. What are the main components of a CD? Each CD has three main components: the interest rate, the term, and the principal. The interest rate is the percentage of interest the financial institution will pay (usually noted as APY, or annual percentage yield). This percentage takes into account compound interest, and provides the depositor the real value of return. The term is the fixed period of time that the money in a CD cannot be accessed. This period is chosen by the depositor prior to the lump sum deposit. Depending on the current interest rate environment, rates can be more favorable as the term increases. The principal is the lump sum deposit the depositor places in the CD account at the beginning of the term. Many financial institutions have a minimum principal balance requirement that must be met prior to opening an account. The depositor’s financial strategy may also affect the amount of principal they decide to deposit. What happens at the end of the CD term? At the conclusion of the term, the financial institution that hosts the account will generally provide a window for the depositor to either withdraw their money or renew the CD term at the current market rate. The window to decide may only be seven to ten days, so make sure to have a decision made ahead of time. If the money is left in the account, it will renew for the same term. The depositor may also have the choice to withdraw the funds from the current CD and deposit them in another CD with a new term and rate. How does a CD compare to a savings account? Both savings accounts and CD accounts are offered by well-insured, reputable financial institutions that provide stability for their depositors. Each type of account requires a relatively small amount of money to open and provide a place to save money for the future. Savings accounts offer easy access to a depositor’s cash, and they allow incremental deposits. Reoccurring transfers or deposits can also be made without any penalties. However, because a depositor has easy access to their money, their interest rate is lower. Savings accounts are frequently recommended to be used for emergency funds or saving slowly for a big purchase. CDs on the other hand offer competitive interest rates that allow a depositor’s money to grow at a faster rate without taking on the same amount of risk that is found in the stock market. This higher interest rate comes with the drawback of reduced access to the depositor’s account and penalties for early withdrawals. The depositor must also open a new CD account if more money is available to be saved. CDs are often used to build wealth with low risk and to save for a long-term purchase. Consult your financial advisor for current CD rates and strategies to see if they might be right for your goals.
