A certificate of deposit, also known as a CD, is a time deposit between an individual and a bank. This common investment instrument is offered at most brick and mortar banks, online banks, and even credit unions.
Certificate of deposits are safe investments, and will earn a greater rate of return when compared against a traditional checking or savings account. Let’s review how they work, the different types and some pros and cons.
How Does a Certificate of Deposit Work?
Understanding the mechanics of a certificate of deposit is quite simple. On a high level, there are four key components to a CD:
- The interest rate
- The term or duration
- The principal
- The institution
A depositor will give the institution X amount of dollars for a specific period of time. In return, the financial instruction will pay the depositor an agreed upon interest rate at an agreed upon interval. The principal balance is returned in full once the CD fully matures, or when the duration of the agreement has elapsed.
Why Would I Open a Certificate of Deposit?
A certificate of deposit provides an investor with a safe, predictable and fixed rate return, without taking on risk. However, the return or yield offered on CD’s are absolutely minimal at the moment, which is forcing investors to look elsewhere.
Where To Open a Certificate of Deposit
Opening a CD is easy! If you visit your local bank, credit union, or even online bank, you’ll likely be presented with numerous CD options.
Selecting the right CD would be the most complicated step. You can shop around for the most competitive package and find the duration interval which will be suited for your needs. Be sure to review a few different options before making your decision. Rates and terms can change depending on the financial institution.
Are CDs Safe?
CDs are considered a very safe investment. They are insured by the FDIC or NCUA up to $250,000. The biggest risk with a certificate of deposit is the fees one would face if they needed to tap into their money before the CD fully matured.
How Do CD Rates Work?
The federal government (Federal Open Market Committee) will meet every 6-8 weeks to determine what the interest rate will be on the federal fund rate. The lower the rate is, the less expensive it is for a bank to borrow money, and as a result a bank will not pay high interest rates to their customers.
If the federal government increased interest rates for the banks, a bank would have more incentive to borrow money from their customers, and as a result would be willing to pay a higher interest rate.
It is extraordinarily cheap to borrow money at the moment (March 2021) and as a result, the interest rates CD’s offer are not attractive.
What Happens When a Certificate of Deposit Matures?
A maturity date is when an investment is due and is repaid to the investor. Maturity dates are found in various investment vehicles, but most commonly they are present in bonds and CDs.
When a certificate of deposit matures, the investor will receive their full principal balance back. For example, if the investor gave the bank $10,000 for a 5 year CD, after 5 years have elapsed, the bank will return that $10,000 back to the investor.
The investor can either take all of the cash and walk away, or can roll it into another investment vehicle.
What Types of Certificate of Deposits Are There?
There are a few different types of CD’s available to an investor. Below are the most common:
No Penalty
A no penalty CD functions just like a traditional certificate of deposit, however, it’s biggest advantage is that you do not pay a penalty fee if you need to withdraw your money early.
High-Yield
A high-yield CD is a certificate of deposit that earns a greater interest return, or yield. These CDs are insured up to $250,000.
Jumbo
A Jumbo CD is a certificate of deposit that requires a large initial deposit, typically $100,000 or more. One of the benefits of a jumbo CD is that it tends to earn a higher yield when compared to a traditional CD, however, you do not take on more risk.
IRA
An IRA CD is purchased through an individual retirement account. The interest one earns on an IRA CD is tax free.
Bump-Up
A bump-up CD gives the depositor the option to ‘bump up’ the interest rate on their CD if rates increase before the CD matures. This is a common option for those who are using depositing money in a CD for multiple years. The interest rate on year one may be 0.35% whereas the interest rate in year three may be 0.70%.
Step-Up
Very similar to a bump-up CD, a step-up CD allows the investor to take advantage of rising interest rates without opening a brand new CD. The step-up CD will automatically adjust at agreed upon intervals. It’s common to see a blended APY when looking at step-up CD’s because the interest rate may change throughout the lifetime of the deposit.
Brokered
A brokered CD is a CD that is purchased through a brokerage firm or a sales representative. Generally speaking, a brokered CD comes with a higher yield as it aggregates a large sum of money from numerous investors.
Advantages and Disadvantages of a Certificate of Deposit
Is a certificate of deposit the right investment vehicle for you? Let’s review some of the benefits and disadvantages.
CD Benefits
- CD’s Are Safe Investments: They are insured by the FDIC or NCUA up to $250,000
- Predictable Returns: The rate of return is fixed and predictable and greater than a standard checking or savings account
- Varying Maturity Date Ranges: CD’s come with a wide range of maturity dates, ranging from a few months to a few years!
CD Disadvantages
- CD’s Have Limited Liquidity: The investor is giving the financial institution money for an agreed-upon period of time. In the event the investor needs their money back before the CD fully matures, the investor will likely be presented with early withdrawal fees.
- Risk of Inflation: Certificates of deposits no longer provide a lucrative yield. The vast majority of CD’s are offering less than a 1.25% APY. Inflation can certainly outpace that!
- Opportunity Cost: If your CD is paying you 1% per year, and another investment can pay you 4% per year, the delta of 300 basis points is your opportunity cost. Your money had the opportunity to earn a greater return, but it was tied up in a CD.
One Piece of the Pie
A CD is a time deposit between an investor and a bank. The bank will pay the investor a small fixed rate yield at an agreed upon interval, for an agreed upon time, and will return the principal balance once the CD matures. In the present day, interest rates on CDs have dropped significantly.
In the world of investing, a CD is just one piece of the pie. There are an unlimited number of investment options out there, and understanding which one is right for you and your financial goals can be overwhelming.
Consulting with a financial advisor is a great way to ensure you’re investing in the right areas. A financial advisor does more than just tell you where to invest your money. They can help you save for a kids college fund, help you navigate the complexities of the tax world, and can give an unbiased view on your spending habits.