CD Basics - How CDs Work
By Justin Pritchard. Banking/Loans Expert
Justin Pritchard helps consumers navigate the world of banking.
Certificates of deposit (CDs) are among the safest investments out there. They’re available from banks and credit unions, and they tend to pay more than savings accounts and money market accounts. The main drawback to CDs is that you have to lock your money up in order to earn the higher interest rate.
CDs are a form of time deposit . In other words, you promise to keep your cash with the bank for a specified amount of time (6 months, 18 months, or a few years).
In return for that promise, the bank agrees to pay you more than you’d get from a savings account – you get a higher annual percentage yield (APY ). Why does the bank pay more? Because they know they can use your money for longer-term investments like loans, and you won’t come asking for it next week.
When you open a CD, you’ll choose how long you want to keep your funds locked up. This time period is called the term. and common terms include 6, 12, 18, and 60 months, although other terms are available.
In general, you’ll earn more when you go with longer terms. But longer terms aren’t always the best idea. For starters, you might need your money before the term ends. If you pull your funds out early (which is usually possible, but in rare cases banks and credit unions have denied these requests), you’ll have to pay an early withdrawal penalty. That penalty will eat into any interest you earned – and it might even eat into your initial deposit – so you’re better off keeping your money in a savings account if you’re going to need it soon.
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At some point, your CD will mature – the term will end and you’ll have to decide what to do next. As you approach the end of the CD term, your bank will notify you that your CD is about to mature, and they’ll give you a few options. If you do nothing, in most cases your money will be reinvested into another CD with the same term as the one that just matured. If you were in a 6 month CD, they’ll put you into another 6 month CD. Note that the interest rate may be higher or lower than the rate you were previously earning – there’s no guarantee that you get to keep the rate.
If you want to do something besides reinvest into a new CD, you need to let your bank know before the renewal deadline. They can transfer the funds into your checking or savings account, or you can switch to a different CD with a longer or shorter term.
to Start Using CDs
To put money into a CD, simply contact your bank or credit union. Let them know how much you want to move and how long you’d like the term to be. You can do this over the phone, and you can also provide instructions online. Be sure to ask plenty of questions about early withdrawal penalties and alternative terms (that might have more attractive interest rates) – or read through that information online.
Once you move money into a CD, you’ll see a separate account on your statements or online dashboard.
Is a Longer Term Better?
Longer term CDs always seem more attractive than shorter term CDs because they pay more. However, they’re not always the best choice. Take a 5 year CD for example: it’s difficult to guess whether or not you’ll need that money in 5 years. What’s more, if you buy a CD when interest rates are low, you may lock yourself into a low-paying CD for the next 5 years – what if interest rates (and therefore CD rates ) rise in a year or two? You might be better off using shorter term CDs that renew with higher rates.
If you’re interested in using longer term CDs, it’s a good idea to use some strategy. The most common strategy CD investors use is the ladder: buy several different CDs with different terms – that way you’ll always have some money coming available, and you won’t lock all of your money into a low-paying CD. For more details, read about CD ladders .
Another way to protect yourself is to use CDs that offer flexibility. They might allow you to:
- Get out early without paying any penalty, or
- “Bump up” your interest rate to a more current (higher rate)
As you might imagine, the more flexible a CD is, the lower the starting interest rate (there’s no free lunch).
What makes CDs safe investments. They are very similar to cash in your savings or checking account. Assuming your deposits are FDIC insured (or covered under NCUA insurance if you use a credit union ), you’ve got a government guarantee: the US government will make you whole if your bank goes belly-up. That’s about as safe as you can get.
With any investment, you need to choose between risk and potential reward. CDs fall on the low risk, low return end of the spectrum. They’re a great place to keep cash that you can’t afford to lose because you intend to spend it within the next few years. If you won’t need the money for several decades, evaluate other investments as well as CDs for your long-term goals.
On the next page, we’ll discuss how to get the best CD rates .Source: banking.about.com