Key insights:
- A certificate of deposit is a time deposit account that earns interest over a set term
- Withdrawing funds before the term ends usually results in an early withdrawal penalty
- A CD ladder strategy can help you balance earning potential with access to your money
- Different types of CDs offer various features to fit your specific financial goals
A certificate of deposit (CD) is a time deposit account that allows you to save by earning interest on deposited funds for a set period. If you’re setting aside money for a specific goal, like a down payment on a house in 2 years, a CD could be a helpful way to grow your funds without temptation to spend them.
You typically must keep your money in the CD account for a specific period, called the term. If you withdraw the money early, you may be charged an early withdrawal penalty. However, there are exceptions, like no-penalty CDs.
Let’s look at how CD accounts work, what types are typically available and how you can benefit from them.
How does a CD account work?
CD accounts are similar to regular savings accounts in several ways. You deposit funds and let those funds accumulate interest over time.
However, unlike a savings account, a CD lets you deposit funds only for a specified period. Once the CD’s term has ended, the CD has reached maturity. You can then either collect your funds plus interest or roll over those funds and interest into another CD term. Many CDs automatically renew, but have a grace period of about 7 days after the term ends. During the grace period, you can withdraw or move your funds without penalty.
When deciding if a CD is right for you, there are a few key factors to understand:
- Terms and rates: CD terms typically range from a few months to 5 years. How much interest you earn depends on the initial deposit amount, term length and the account’s annual percentage yield (APY).
- Minimum deposit requirements: Most financial institutions require a minimum opening deposit to start a CD. Depending on the financial institution and the type of CD, this requirement could range from a few hundred to a few thousand dollars.
- Early withdrawal penalties: For most CD accounts, once you deposit funds, you cannot withdraw the funds until the account matures. If you do, you’ll pay an early withdrawal penalty, which is often equal to a few months’ interest.
What is a CD ladder?
A CD ladder is a savings strategy in which you deposit money into multiple CDs with staggered maturity dates. For example, if you have $30,000, you might put $10,000 into a 1-year CD, $10,000 into a 2-year CD and $10,000 into a 3-year CD.
This laddering approach can help you optimize your savings. It allows you to earn potentially higher interest on longer-term CDs while maintaining some liquidity as your shorter-term CDs mature. When a CD in your ladder matures, you can either withdraw the money or reinvest it into a new CD at the top of your ladder.
Pros and cons of a CD account
Before opening an account, it helps to weigh the pros and cons of CDs to make an informed decision for your finances.
The main advantage of a CD is the favorable interest rate. CDs generally offer higher rates than traditional savings accounts, which could earn you more on your deposit over time. Additionally, CD accounts are protected if the bank or credit union is FDIC insured. This helps make CDs a low-risk way to save and grow your money.
On the downside, CDs have less flexibility. Your funds are locked away for the duration of the term, and you’ll likely face an early withdrawal penalty if you need to withdraw funds in an emergency. Fixed interest rates can also carry some risk. If market rates go up after you open your account, you might miss out on those higher returns.
