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What Is a CD? (Certificate of Deposit)

A CD (or Certificate of Deposit) is a financial instrument that holds your money for a pre-specified amount of time in return for payment of interest that is (hopefully) higher than what a regular bank savings account would typically pay. 

The Federal Deposit Insurance Corporation (FDIC) insures most bank-issued CDs for up to $250,000 per account holder. CDs began to be FDIC-insured when it was formed in 1933.

CDs have long been a popular investment choice for investors who want to keep their money safe, secure, and close by but still earn an attractive interest rate. But the investment isn’t ideal in every situation, nor is it the right solution for every investor.

Table of Contents
  1. How Does a CD Work? 
    1. Fixed Rate
    2. Fixed Term
    3. Most CDs Have Early Withdrawal Penalties
  2. CD or Savings Account?
  3. Where Can I Get a CD? 
    1. Current CD Rates
  4. CD or Mutual Fund?
  5. Should I Invest in a CD?
    1. The Impact of Inflation on Investment Returns
  6. Final Thoughts

How Does a CD Work? 

The process for purchasing a CD is fairly straightforward. Unlike a mutual fund or an ETF, you can’t make regular contributions to a CD. You purchase the investment upfront, in one lump sum. Minimum deposit amounts usually range between $500 and $2000, depending on where you buy your CD. Here’s a closer look at three key characteristics of CDs.

Fixed Rate

The draw to CDs is that they offer a fixed rate of interest return that’s more attractive than the offering bank’s savings interest rate.

The rate you get on your CD usually remains the same, although some CDs have bump-up clauses that allow the account owner to bump the rate up once during the CD term if interest rates have risen. 

As such, account holders open the CD to get the higher rate, and the bank is assured it can use the cash to make money for the specified term of the CD. 

Fixed Term

Another identifying factor of a CD is that it has a fixed term. You’ll know at the onset of your CD purchase whether your investment will be locked in for six months, 12 months, or up to five years. Generally speaking, the longer the lock-in period, the higher the interest rate.

The fixed term makes CDs less liquid than a savings account.

Most CDs Have Early Withdrawal Penalties

Because of the fixed terms of CDs, banks will typically charge early withdrawal penalties if you break your CD contract and opt to cash it out before the maturity date.

Early withdrawal penalties on CDs usually amount to a portion of the interest you would have earned had you kept the CD in for the full term. For example, a 12-month CD might have an early withdrawal penalty equal to three months of earned interest, whether you’ve earned it or not. 

CD or Savings Account?

When deciding whether to open a CD or keep your money in a savings account, it’s important to consider a couple of factors, starting with the interest rate.

For example, when researching for this article, I noticed Discover is currently paying 1.30% interest on its high-yield savings account. But Discover is paying a minimum of 2.00% interest on its CD offerings. If the difference is large enough for you to be willing to lock up your money for a specified period of time, go for it. 

Second, be sure you aren’t going to need the money you’re depositing into a CD before the CD comes to maturity. 

In other words, if you’re thinking you might need to get another vehicle within the next 12 months, don’t lock your car savings in a 2-year CD.

You could risk losing any interest you’d planned on earning if you have to buy that car in three months because you’ll get hit with a penalty, or you might have to take out a temporary loan to get the car. 

In short, if you’re okay with locking your money up and are attracted to the higher interest rate, go ahead and get that CD.

Where Can I Get a CD? 

CDs are available at almost any bank, including popular online-only banks. As you’ll see from our rate comparison below, online banks pay higher interest on Certificates of Deposit.

Current CD Rates

If you’ve decided that you may want to invest in a CD, you can always check out your local banks and credit unions to see what types of interest rates they’re offering. 

Here are some examples of CD rates from popular banks as of this writing:

Bank Name Current APY Term Min. Deposit
Ally Bank 1.90% 12-month $0
Discover Bank 2.00% 12-month $2,500
Axos Bank 0.20% 12-month $1,000
Wells Fargo 0.01% 12-month $2,500
U.S. Bank 0.05% 12-month $1,000

As you can see, online banks typically offer the best CD (and other) interest rates. Brick and mortar banks, in part due to higher overhead costs, just can’t compete with online bank CD rates.

CD or Mutual Fund?

The deciding factors are pretty clear when choosing between a CD or a mutual fund.

CDs fall into the safety asset class. Your principal balance is not only guaranteed by the issuing institution; the FDIC also insures it in most cases.

Unless you choose to cash out your CD before the term you committed to, you’ll get your principal investment back, as well as the interest you were promised.

Mutual funds don’t have the same guarantees and, except for a money market fund, are much riskier than CDs. Most mutual funds are comprised of individual stocks that are constantly rising and falling in value.

The advantage mutual funds hold over CDs is the potential for higher returns over the long run. As an example, look at the 10-year annualized return (2010-2020) on a few of the most popular long-running mutual funds of today (pre-pandemic return averages):

  • T. Rowe Price Health Sciences Fund ((PRHSX): 20.3%
  • Vanguard Wellington Fund Investor (VWELX): 9.7%
  • Fidelity Total Bond Fund (FTBFX): 4.4%
  • Vanguard 500 Index Fund Admiral ((VFIAX): 13.8%
  • Fidelity Strategic Dividend and Income Fund (FSDIX): 9.8%

(Source: Kiplinger)

Compare that with CD interest rates from the same time period (2010-2020), and you’ll find that you’d be lucky to earn a high of just over 2% on a CD in 2010, while the rates steadily dropped as the decade wore on. 

If you’re looking at average interest rate earnings alone, the mutual fund wins for long-term investors. However, mutual funds are much riskier when investing for a shorter term (three years or less, for example).  

Should I Invest in a CD?

Before purchasing a CD, determine what your investment objective is. If your main priority is to protect your capital investment, a CD (or savings account) is likely your best bet. And if you can afford to lock in your funds for a predetermined period, the CD probably wins out over the savings account.

If your main objective is to generate the highest possible returns over the long-term, you’re better off with a market investment, like stocks, mutual funds, or ETFs.

The Impact of Inflation on Investment Returns

Before investing in a CD, it’s important to realize that your returns are unlikely to stay ahead of, or even keep up with, inflation. That’s especially true here in 2022 when inflation has spiraled to levels we haven’t seen in decades.

Your money loses its purchasing power every year that your investment returns don’t keep pace with the inflation rate. That’s why always important to work to protect your portfolio against inflation.

CDs don’t pay out a high enough return to do that. That said, if investing in the stock market makes you lose sleep at night, a CD will relieve your anxiety. CDs can also be a smart choice for consumers who have a tough time saving and want to save some money for emergencies without being tempted to touch them.

Since there’s very little risk of loss and you can access the money quite quickly if the need truly arises (even if you have to take a penalty), using a CD for this purpose may be wise. 

However, CD investing will leave you highly disappointed if you’re looking to invest for the long term (over five years) and are comfortable with the risk vs. reward aspect of other investments such as mutual funds or ETFs. 

Final Thoughts

Certificates of Deposit can be useful if you’re looking for a shorter-term investment that poses little or no risk of capital loss and offers a guaranteed rate of return. 

However, CDs are not your best option if you’re searching for an investment that will outpace the inflation rate and help you grow your wealth over the long term.

The post What Is a CD? (Certificate of Deposit) appeared first on Best Wallet Hacks.



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