What is Certificate of Deposit (CD)?
A Certificate of Deposit (CD) is a type of savings account available at banks and credit unions that offers a fixed interest rate in return for leaving your money deposited for a set period of time. The term can range from a few months to several years. CDs are considered low-risk investments because they are typically insured by the FDIC up to $250,000 per depositor, per insured bank.
CDs are a significant tool for disciplined saving and investing, as they require you to lock in your money for a period known as the term length. This prevents you from the temptation of withdrawing and spending, which can be beneficial for those with a financial plan in mind. You encounter CDs when you're considering ways to save beyond a regular savings account, potentially when interest rates in the economy are high.
How Certificate of Deposit (CD) works
When you purchase a CD, you choose the amount to be deposited and select a term length. Let's say you invest $10,000 in a 3-year CD with a 3% annual percentage yield (APY). Once the 3 years pass, you'll receive your initial $10,000 plus $927.27 in interest.
| Initial Investment | Term Length | APY | Interest Earned | Total Value at Maturity |
|---|---|---|---|---|
| $10,000 | 3 years | 3% | $927.27 | $10,927.27 |
Interest on CDs is typically compounded annually or monthly. The more frequently the interest is compounded, the more you earn. However, interest rates on CDs are generally fixed, meaning once you open the account, the rate won't change even if the market fluctuates.
Why Certificate of Deposit (CD) matters for your money
CDs are important for those who want to earn higher interest than a traditional savings account without taking on the risks of stock market investments. For instance, if your savings account offers 1% APY, a CD with a 3% APY over three years is far more advantageous.
They are especially useful for consumers with specific future financial goals, like purchasing a home or saving for a child's education, where you can align the CD term with when you'll need the funds. The fixed interest rate means you know exactly how much you'll make by the end.
By committing funds to a CD, you can resist the urge to dip into your savings for impulse purchases, thus supporting better financial habits over time.
Common mistakes
- Early Withdrawal Penalties: Assuming you can withdraw your deposit early without penalties. Most CDs charge a fee or forfeit interest if cashed out early.
- Interest Rate Shopping: Not comparing rates between institutions before selecting a CD, possibly missing out on better returns.
- Term Length Misalignment: Choosing a term length that doesn’t match your anticipated cash needs, leading to forced early withdrawals.
Related concepts
Savings Account: A basic account with lower interest rates for liquid savings. Money Market Account (MMA): Offers higher interest than savings accounts, with some check-writing abilities. Treasury Bonds: Government-backed investments with longer terms. IRA CD: A CD held within an Individual Retirement Account, offering potential tax advantages. Laddering: A strategy of staggering CD maturity dates to balance liquidity and earning potential.