What is a CD and is it right for me?
Saving money can be one of the most important factors when it comes to long term financial health. Although we all know we should save money, we’re not often taught how. It can also be confusing knowing what available options will help us make the most of what we’ve saved. There are many different types of savings accounts that serve all different types of financial situations.
You may have worked hard to save a significant amount, but are now wondering what to do with it or how best to earn more money from it. That’s where a certificate of deposit (CD) can come into play, depending on when you anticipate needing access to those funds in the future. A CD with a good interest rate and terms that suit your needs can help you reach your overall savings goals over time.
Here, we’ll focus on the rates, rules, and benefits of CDs so you can determine if it’s the right choice for you.
What is a CD?
A CD is a low-risk way to invest your money, but only if you’re sure you won’t need to access the money for a while. As a less flexible savings account, it usually comes with a higher interest rate at the cost of locking funds for a period of one to five years.
With a CD, you invest your money at a set interest rate for a set period of time, typically ranging from between a few months to a few years. The longer you agree to leave your money in the account, the more interest you earn. If you do withdraw money early, you pay a penalty.
Like savings accounts, they are backed by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per account holder, per account ownership. Basically, if your bank fails or can’t return your money, the FDIC will pay you the lost money up to the insured limit. You can learn more about FDIC deposit insurance here.
CD interest rates
There are a few terms that are important to understand when it comes to interest rates, especially with regard to CDs.
Interest: Interest is essentially the amount you earn back from your money when you keep it in a savings account.
Fixed interest rate: The rate of payback you earn on your money that stays the same for a certain period of time.
Variable interest rate: An interest rate that changes over time, which also means it can decrease. Most normal savings accounts use this type of interest.
Annual Percentage Yield (APY): How much money you make by keeping your money in this account for one year.
Term: This is the length of time you agree to leave your money in an account.
Principal: This is the amount you agree to deposit when you open the CD.
Compound interest: Like savings accounts, CDs can earn compound interest. Compound interest is when you earn interest on top of already earning interest on your principal amount. Essentially, if you have already earned interest on the amount you had in your CD, you will now earn interest on that larger amount, and so on.
Most savings accounts have an interest rate that changes over time. This means the amount you earn on your money may go up or down while you have the money in the account.
When it comes to CDs, most of the time they offer a fixed rate which stays the same the entire time your money is in the account, until the term ends.
The most important thing to understand about interest rates is the higher they are, the more money you make over time.
Access to your money in a CD
This is where CDs can get complicated. Here are a few more important terms to know.
Maturity: When your term is up and you can withdraw the money without a penalty.
Early Withdrawal Penalty (EWP): The amount you pay if you take out money prior to account maturity.
Default action: What happens when the CD matures if you do nothing.
Rollover: When your money is placed in a new CD with the same length, or term, as the original CD after it matures.
But what happens when the term ends and the CD matures? That depends on the agreement with your bank.
When your account matures, you will usually need to withdraw your money or transfer it into a different account. If you don’t do this after a certain amount of time, your bank will usually roll over your money into a new CD with the same term. Since the CD is technically a new one, the interest rate could be different than the original one.
It can be a good idea to set reminders for your CD maturity date, so you don’t accidentally get locked into a rollover.
Is a CD right for you?
So, is a CD right for you? It depends. This type of account can help you save money for specific events, or even just avoid the temptation to spend money rather than saving it. Ask yourself if you can afford to set aside money for a CD account, as well as when you think you’ll need it in the future.
Given that most CDs require a lump sum up front and don’t allow you to make subsequent contributions after the initial deposit, a savings account might be better if you want to add funds bit by bit as you can afford it.
If you can afford to let some of your money sit for a while, or if you have your eye on a long term savings goal like a down payment on a home, a CD might be a good option for you. That can be especially true if you are starting with a larger opening balance that will accrue more interest for you. Unlike investing in the stock market, there is less volatility with a CD when it comes to putting your money to work for you.
Because you will only be able to access your funds by paying an Early Withdrawal Penalty, CDs are not a good choice for emergency funds. By their nature, emergency funds are intended to give you immediate access to funds when you’re in a pinch, such as an accident or illness, or an unanticipated home repair.
If you want your money to grow and you won’t need it for a while, shop around for a CD with a longer investment term. Typically, CDs with longer periods offer higher interest rates.
There is no one-size-fits all approach to saving money. It greatly depends on how much and how often you can save, whether or not you need immediate access to those funds, and what your long term savings goals are. Under the right circumstances, a CD can be a powerful tool for maintaining long term financial health. But, as with any financial decision, the first step is having all the information you need to make the right choice for you.
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