How Do CDs Work?

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Disclaimer

A certificate of deposit, more commonly known as a CD, is a special type of savings account. You deposit your money into the account and agree not to make any withdrawals for a certain period of time. At the end of that time, you get your money plus whatever was earned in interest back.

Want to know more? We’ve got you covered. We’ll dig into traditional CDs, including what they are, how they work and whether they’re right for you.

Just How Do CDs Work?

A traditional CD is essentially a time-bound deposit. In exchange for earning interest, you enter into an agreement that lets the bank use your money for a fixed time. The bank rewards you by paying you a higher interest rate than it does for a regular savings account or money market account. This works for the bank because they can use your money to earn more money—such as by extending other customer’s long-term loans.

When opening a CD, you choose how long you want to give your money to the bank. This is known as the term length. Common term lengths for traditional CDs include 6, 12, 18, 24 and 30 months and 3, 4, 5 and 6 years. Some banks and credit unions also offer a custom term length.

What Is a Traditional CD?

A traditional CD can also be called time deposits, fixed deposits or term deposits. Unlike a traditional savings account that lets you withdraw money anytime, a CD has a fixed term and:

  • Requires a minimum deposit amount that is higher than a savings account
  • Allows you to withdraw money at the end of the term—earlier withdrawals can be made only by paying a penalty
  • Don’t let you add money after your initial deposit

By opening the CD, you agree to leave your one-time deposit in the account for a fixed amount of time. In an emergency, you can withdraw funds early, but you’ll have to pay an early withdrawal penalty. In exchange for agreeing to a set term length, you get a fixed interest rate, typically one that is higher than a traditional savings account. Generally, the longer the term length, the higher the interest rate.

Like traditional savings accounts and money market accounts, traditional CDs opened at a bank or credit union are protected by the Federal Deposit Insurance Corporation (FDIC)or National Credit Union Administration (NCUA) for up to $250,000 per person. Many analysts consider CDs to be one of the safest forms of investment offers. They also pay higher interest rates than money market accounts and savings accounts, making a CD a more lucrative low-risk option for investors.

Considerations Before You Open a CD

You might think that opening a CD with the longest term is a good idea. But having a very long term may not be the best thing to do. For example, you may need your money before the time period is up. If you choose to remove your money before that happens, you can be penalized by the bank or credit union. Here are some other things to consider before opening a CD:

  • Do CDs pay interest monthly? The interest rate on a CD is the annual percentage yield (APY). This is how much interest you will earn after a year. However, many banks compound interest on CDs monthly. Some CDs allow you to choose to take the monthly interest earned out. Others let you cash out the CD only at the end of the term length.
  • Can you lose money in a CD? No, you can’t lose money on a CD as long as it insured, which is one reason they can be attractive investments. FDIC and NCUA coverage is limited to $250,000 per person, per bank, per account category. So, if you have multiple CDs at the same bank or credit union, the total of all CDs is only insured up to $250,000. As long as you’re under that, you’re guaranteed to get your money back if your bank or credit union goes under for any reason.
  • How much interest will I earn on a CD? The amount of interest you earn on a CD varies depending on how long the term is, the amount you deposit and the APY. In general, longer terms, higher interest rates and larger deposits will net you more interest gains.

So, are CDs worth it? The bottom line is that, before you invest in a CD, you need to make sure you’re confident that you won’t need the money before the maturity date or that you’re comfortable paying a penalty if you need the money earlier. If you’re not sure, consider choosing a high-yield savings account or money market instead.

When Your CD Matures

When your CD reaches the end of its term, it matures. Toward the end of your term, your bank will inform you about its impending maturity and present you with options, including taking your money and walking away or renewing for another term length. Sometimes, if you don’t withdraw your money, the bank will automatically reinvest your balance into another CD with the same term length as the first.

How to Open a CD

Opening a CD is relatively easy. You can apply online or go in person to your bank or credit union. When researching online options or talking to your bank, ask questions, know your investment rationale and find out about withdrawal penalties and possible alternative products.

CD Options

Longer CD term lengths can be more attractive than shorter term lengths. If you purchase a CD when interest rates are low though, you end up with a lower APY for the rest of your term. A shorter term length may actually let you renew for a higher APY.

A CD ladder—or CD laddering—is a common CD tactic used to help maximize returns on CDs. Laddering is using multiple longer-term CDs opened at different times and/or for different term lengths. This disbursement strategy gives you access to money at various times and rates. You avoid being locked into any single term, interest rate or maturation date. And you can reap the benefits of a CD without needing to risk paying penalties if you need money early.

CDs and Your Credit

A CD won’t impact your credit one way or another, but a bank or credit union may make a hard pull or a soft pull of your credit when you apply for a CD. Most only do a soft pull, but it won’t hurt to ask before you apply if a hard pull is a concern.

CDs won’t help you build your credit history. However, some banks offer a CD secured loan if you open a CD. This is a loan that uses your CD deposit as collateral. If you default on your loan payments, your CD will be taken to pay the loan. Making timely payments on the loan can help you build your credit as long as your bank or credit union reports your payments to all three credit bureaus.

To learn more about investment options or find the details on popular savings accounts, check out Credit.com’s personal finance resources.

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Source: credit.com