You’ve probably heard of a certificate of deposit, or CD. It is a type of savings account that offers a higher interest rate in exchange for a fixed term deposit. But how does a certificate of deposit work and who are they suitable for? In this article, we’ll explain how CDs work and why they might be a good investment for you.
How Does A Certificate Of Deposit Work?
A certificate of deposit (CD) is a type of savings account that has a fixed interest rate and a fixed term. This means that you agree to keep your money in the account for a certain period of time, and in return, the bank agrees to pay you a certain amount of interest. CD terms typically range from a few months to a few years, and the longer the term, the higher the interest rate.
You can usually withdraw your money before the end of the term, but you will usually have to pay a penalty, which is typically a few months’ worth of interest. Some banks also allow you to renew your CD at the end of the term, so you can keep your money invested and continue to earn interest.
Interest earned on cash in CD accounts is compounded. This means interest is earned on both your initial capital and on top of the interest you earn. This allows your money to grow quicker.
CDs are a great way to save money and earn interest, but they are not without risk. If you need to withdraw your money before the end of the term, you will lose out on some interest. Additionally, if interest rates rise during the term of your CD, you will earn less interest than if you had invested in a different type of account.
However, CDs can still be a great way to save money and earn interest, as long as you understand the risks and features involved.
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CD Account Features
There are four main things savers should take into account when opening a CD account, these are; the interest rate, the term, principal deposit requirements, and other requirements such as early withdrawal penalties.
1. Interest rate: The interest rate is the percentage of the principal amount that the bank pays you for keeping your money in the account. The higher the interest rate, the more money you will earn on your deposit.
2. Term: The term is the length of time that the account will be open. CD terms can range from a few months to several years. The longer the term, the higher the interest rate will usually be.
3. Principal deposit requirements: Most CD accounts require that you deposit a certain amount of money to open the account. This is called the principal deposit. The principal deposit is the amount of money that you will earn interest on.
4. Other requirements: Some CD accounts may have other requirements, such as early withdrawal penalties. Early withdrawal penalties are fees that the bank charges you if you withdraw money from the account before the end of the term.
CD Account Advantages And Disadvantages
CD accounts have a number of advantages and disadvantages.
-They offer a higher interest rate than most savings accounts and money market accounts.
-They are a safe investment since they are FDIC insured.
-As they are fixed term products it can help to prevent unnecessary access to cash in the short term.
-You may be charged a penalty if you withdraw money before the CD matures.
-The interest rate on CDs is usually lower than the rate of return on other investments such as stocks or bonds.
-CDs typically have a fixed interest rate, so if rates rise you will not benefit from the increase.
-Cannot usually make additional deposits as with other types of savings accounts.
Why Are CD Rates So Low?
If you’re wondering why are CD rates so low, it’s because the Federal Reserve has until recently kept interest rates near zero. That’s made it harder for savers to earn a decent return on their money. However, over the past year, the Federal Reserve and other central banks have been increasing interest rates in order to combat rising inflation. This has led to banks raising interest rates on their savings accounts, including CDs.
However, not all banks are raising their interest rates on savings accounts. Most of the large national banks have seen little to no increase on the rates they offer over the past several years. Yet many savers continue to stick with them regardless, when they could be getting a much better rate of return by simply shopping around.
For example, Bank of America CD rates are pitifully low – currently they pay a measly 0.03% APY across it’s entire range of fixed term CD accounts, regardless of length of term. And you even require a minimum of $1,000 to open one. With rates like that is it any reason savers are asking are CD accounts worth it?
But by simply shopping around you could find many alternative banks offering much higher yields. A good place to compare accounts is a savings marketplace such as SaveBetter.
To put that into perspective, assume you had $10,000 to deposit into a CD account for 1 year. With Bank of America, you would earn just $3 in interest at the end of the 1 year term. Hardly worth the bother of opening the account is there?
But compare this to the equivalent 1 year term CD account via SaveBetter, which currently is offered by America First Credit Union. At the end of the term you would earn $450 in interest payments from the same $10,000 deposit earning a rate of 4.50% APY. That is a huge difference.
But why the huge disparity in interest rates between these banks? Well, many people simply do not shop around for better deals. They either walk into their nearest bricks and mortar bank branch or remain with the same bank they first opened their account with.
Before the internet, savers really didn’t have much other option but to use their local bank to take out a savings account. But the internet has allowed banks to offer products online to a wider range of people, increasing competition.
Some banks are even digital only banks. Having no branches means lower operating costs, in turn these cost savings can be passed onto savers by offering higher interest rates.
The largest banks do not need to bother trying to compete for your money whereas the smaller challenger banks do. Many of these are community focused banks or credit unions whose interests are more aligned with their customers.
Just spending a few minutes looking for a better deal could potentially earn you hundreds, possibly thousands of dollars in extra interest income each year.
Savings marketplaces like SaveBetter make this easy, but how does a certificate of deposit work through SaveBetter? Well, the online platform allows you to compare the best rates from a variety of financial institutions across a wide range of savings products. In addition to CD accounts, this also includes other high yield savings and money market accounts.
You can simply find the best products and open multiple accounts within the one secure online platform – no need to create separate accounts at each bank. This makes it easy to create a CD laddering strategy and manage your savings all in one place.
Another big plus is that unlike many of the big national banks, you don’t require a large deposit to open an account, initial deposits are as low as just $1, and there are no fees.
What Is A CD Laddering Strategy?
A CD laddering strategy is when a saver buys multiple CDs with different maturity dates, so that they can “ladder” them. This means that every time a CD matures, the saver can choose to either cash it in or reinvest it.
This strategy can benefit savers because it allows them to have more flexibility with their money. For example, if a saver needs to access some of their money before the CD maturity, they can do so without having to pay a penalty.
Additionally, a CD laddering strategy can help savers earn more money in the long run because they will be able to take advantage of higher interest rates as they become available.
There are a lot of odd numbered term lengths that banks offer such as 7 months, 15 months, 17 months and so on. So it’s usually pretty easy to put together a CD laddering strategy suited to your goals as they can be structured in multiple ways to allow access to your cash at regular intervals whilst still maximizing your return.
CD Ladder Calculator
Use the below CD ladder calculator to help you decide on a CD laddering strategy. CD accounts receive compound interest which helps your deposit to grow quicker as it earns interest on interest. The longer you leave it to accumulate, the more your cash will grow.
Simply add in your initial deposit, the interest rate, number of years to maturity and the period that the interest is compounded. This compound interest calculator can be used to find the return on any type of savings account.
Found this CD ladder calculator useful? Why not check out our net worth calculator and learn how to increase your net worth.
What Happens When A CD Reaches Maturity?
A CD reaches maturity when the initial investment period has ended and the money can be withdrawn without penalty.
The saver has three options at this point: let the CD automatically roll over with their current provider, transfer the money to another account with the same provider, or transfer the money to a new account with a different bank.
For most accounts the default option is for it to roll-over. The bank will usually contact you before reaching your CD maturity date, allowing you time to elect one of these options.
Roll-over: Letting the CD automatically roll over is the simplest option and has the advantage of being hassle-free. However, it may not be the best choice financially since the interest rate on the CD may be lower than what is currently available from other providers. And you will be locked into this new account for the length of the term.
Transfer to another account: Transferring the money to another account with the same provider may get the saver a better interest rate, but it is still limited to what is offered by that particular bank.
Transfer to a new provider: Transferring the money to a new account with a different bank may be the best option financially since you can shop around for the best interest rate. However, it is important to compare any transfer fees that may be charged before making this decision.
In Which Situation Would A Certificate Of Deposit (CD) Be The Best Banking Choice?
When an individual is looking for a place to keep their savings safe and grow their money over time, a certificate of deposit (CD) may be the best banking choice. CDs typically have higher interest rates than other types of savings accounts, making them a good option for those who want to earn more on their money.
Additionally, CDs typically have fixed terms, meaning that the money will be held for a specific period of time and cannot be withdrawn until the CD maturity date. This can be helpful for savers who have trouble keeping their money in a savings account and sticking to their savings goals. Some CD accounts may be suitable for creating a contingency fund.
Alternative Savings Options
A CD account may not be suitable for everybody and there are several alternative savings options available including regular savings accounts, high yield savings accounts, money market accounts and even interest bearing checking accounts.
A regular savings account is a type of account offered by banks and credit unions that allows customers to deposit money and earn interest on their balance. These accounts typically have low interest rates and require a minimum balance to avoid fees. Regular savings accounts are a good option for customers who want to earn interest on their deposits and have easy access to their money, but they usually offer very low interest rates.
A high yield savings account is a type of account that offers a higher interest rate than a regular savings account. These accounts typically have higher minimum balance requirements and may have restrictions on withdrawals. High yield savings accounts are a good option for customers who want to earn a higher return on their deposits and are not concerned about having easy access to their money.
A money market account is a type of account that offers a higher interest rate than a regular savings account and allows customers to write checks against their account balance. Money market accounts typically have higher minimum balance requirements and may have restrictions on withdrawals. Money market accounts are a good option for customers who want to earn a higher return on their deposits and have the ability to write checks against their account. These shouldn’t be confused with money market funds, which are a type of investment fund.
An interest bearing checking account is a type of account offered by banks and credit unions that allows customers to earn interest on their account balance. These accounts typically have low interest rates and require a minimum balance to avoid fees. Interest bearing checking accounts are a good option for customers who want to earn interest on their deposits and have easy access to their money.
Are CD Accounts Worth It?
We often get asked the question, are CD accounts worth it? The answer is, it depends on what your circumstances and savings goals are. There are a lot of different options out there when it comes to saving your money. You can put it in a savings account, invest it, or even put it into a CD account. But which one is the best option for you? It really depends on your individual situation and what your goals are.
CD accounts generally have higher interest rates than savings accounts, so if you’re looking to grow your money quickly, they may be a good option. However, they also have stricter withdrawal rules, so you need to make sure you won’t need the money before the CD matures.
If you wish to save cash but don’t want to lock it away for a fixed period of time then you could consider a more flexible alternative such as high yield savings or a money market account. The interest rates are likely to be a little lower than a CD, but you can access your money quicker and usually without penalty.
For those savers that don’t require short term access to their cash, want to earn a better rate of return and are happy to take on some risk then you could consider investing. Get started by viewing these 21 types of investment assets to grow wealth.
If you’re not sure which route to go, talk to a financial advisor to get some guidance.
To recap, we have learnt the following points in this article;
- How does a certificate of deposit work?
- CD account pros and cons
- Creating a CD laddering strategy
- Your options at CD maturity
- Alternative savings products
Now that we know how a CD works, it’s time to start thinking about whether or not it’s the right investment for you. So, are CD accounts worth it?
If you’re looking for a safe and secure way to grow your money, a CD could be a good option. But remember, there are other options out there, so make sure you do your research before making any decisions.