You have many options when it comes to personal savings products. Most people open checking and savings accounts, and you need them, but these accounts typically offer very low interest rates. In the event you find yourself with a surplus of cash you do not have an immediate need for, opening a Certificate of Deposit (CD) is a good way to put your money to work for you. You will earn more than if you just let your extra cash sit in a savings or checking account.
If you think a CD might be a good addition to your portfolio, be sure to research the different types available on the market and thoroughly understand the terms of the CD you choose.
What is a Certificate of Deposit (CD)?
A Certificate of Deposit (CD) is a savings certificate issued by a bank or deposit broker. CDs issued by banks are usually insured by the FDIC. A CD is basically a promissory note that specifies the terms and amount of debt, interest rate, maturity date, date and issuing organization, and the issuer’s signature.
CDs are one of the safest investments you can make. While they are low-risk and low-return compared to other investment types, they usually offer higher interest rates than common personal savings tools like checking and money market accounts. When you open a CD, you invest a fixed
sum of money for a specified period, typically six months or one or more years. Upon payout, you are guaranteed your initial investment plus any earned interest. All gains are taxed as earned income unless you choose a tax-free account.
Common Types of CDs
Traditionally, CDs were offered with a fixed interest rate and options were limited. Now there are many variations available to accommodate investor’s individual financial situations.
Traditional CD – Traditional CDs offer a fixed interest rate over a specific time. At the end of the term, you can make a withdrawal or roll your funds over to another CD. You typically pay a penalty if you take an early withdrawal. A traditional CD with a high minimum balance is referred to as a Jumbo CD.
Variable-rate CD – Variable-rate CDs are linked to a market index. They may also allow you to take advantage of future interest rate increases.
Liquid CD – Liquid CDs allow for early withdrawal. They usually offer lower initial interest rates in exchange for this flexibility. However, the rates are still higher than money market accounts. Zero-coupon CD — A Zero-coupon CD does not pay annual interest. The interest payments are re-invested so that you can earn interest on the higher total deposit amount. Zero-coupon CDs have higher interest rates than other types of CDs, but you will have to pay taxes on the re-invested interest.
Callable CD – Callable CDs entitle the bank or issuing organization to shorten the term of your CD, returning your initial investment plus earned interest. Banks may take advantage of this when interest rates fall below the initial offered rate. This type of CD usually offers a higher interest rate than others.
IRA CD – IRAs are traditional CDs held within a tax-advantaged individual retirement account (IRA).
Opening a CD
Once you have decided which CD best fits your financial situation, opening the account is relatively simple. If you want to open a CD, make sure you have done your research, have the funds available, and are prepared with the appropriate information and identification.
A couple of terms you should understand are Annual Percentage Rate (APR) —the current interest rate offered by the bank— and Annual Percentage Yield (APY)—the earnings over the lifetime of the CD as your money compounds. Compounding refers to the growth of your investment over time.
To open a CD:
- Find a financial institution you trust. It could be your bank or a deposit broker. Do your research and make sure you choose somewhere that can offer you a CD that is FDIC insured.
- Ask about the deposit amount required to open the CD. Most financial institutions have a minimum.
- Decide how much of your money you want to contribute to the CD. What is your current financial situation? Do you have enough money to tie up in an investment? Keep in mind that the money will not be readily available to you once you fund the account.
- Discuss the APR, APY, time period, maturity date, and other details about the CD you choose with a financial professional. Make sure you thoroughly understand the terms of the account. Ask questions! Also assess your risk tolerance. While CDs are relatively low risk, it is possible that inflation can outpace and diminish your returns over time.
- Make sure you have the appropriate forms of identification ready. You may be asked for your driver’s license, social security number, or taxpayer ID.
- Obtain an application from your financial institution or open an account online. Complete the
application and attach a personal or certified check or transfer funds electronically.
It may be tempting to immediately opt for the high return CDs, but that may or may not be the best solution for your financial situation. Consider your financial goals before making any decisions. You may already have a financial plan. If so, you’re one step ahead. If not, consider working with a financial planner to create a portfolio to help you reach your financial goals. Once you have a clear set of financial goals for your future, you can decide if a CD is a good addition to your plan.