A Certificate of Deposit, or CD, is a savings product sold by banks, credit unions, and other financial institutions. Also known as “time deposits,” CDs require holders to deposit their money for a predetermined duration. This time restriction allows the issuing institution to invest the deposited funds. In return, you typically receive a potentially higher interest rate than with a savings account.
How does a CD work?
There are many types of CDs, though at their core they all work very similarly:
- CDs worth less than $100,000 are sometimes called small CDs, while those worth more are known as jumbo CDs.
- Bump-up CDs enable you to “bump up” to a better interest rate if one becomes available during your CD’s term, though they typically offer a lower starting interest rate in exchange.
- Conversely, a callable CD offers higher interest rates, but the bank or credit union can choose to “call it in,” meaning cash it out, before the term is up (and after a certain minimum timeframe), which it may do if rates have lowered significantly.
- There are also liquid CDs, which allow you to tap into them earlier without penalty, but these products are usually attached to lower interest rates.
Benefits of a CD
CDs are one of the most conservative products you can purchase—like a savings account, your first $250,000 is protected from loss by the FDIC. Since the CD’s value doesn’t fluctuate with the stock market, CDs can make it easier to plan your retirement income.
Risks of a CD
CDs are typically considered stable, but they aren’t 100% liquid, meaning you can’t tap into the money whenever you want. If you withdraw the money early, you typically face a penalty.
Most CDs pose almost no investment risk. The downside can be that in exchange for such low risk, the upside isn’t very high, either. While CDs almost always generate more than savings accounts, interest rates rarely go much higher than inflation. This means that though you might gain 2% over 5 years, the relative value of a dollar may decrease a similar amount, leaving you with only a little more than you originally started with.
Pay attention to the annual percentage yield (APY), which tells you how much you’ll earn on your money. This is different (and arguably more important) than the interest rate: the APY takes into account compounding interest, which is what happens when the gains you make on interest are added to the investment and start earning their own interest. Banks can choose to compound your interest every year, every month, or even every day; the CD’s APY clarifies these calculations into an easy-to-understand number.
The interest your CD generates is normally taxable each year. CDs can be combined with IRA money to gain valuable tax benefits. Despite not being an aggressive income generator, CDs can be an extremely important part of a balanced, responsible retirement savings strategy.