What is a Certificate of Deposit (CD) and How It Can Help You Save?

What is a Certificate of Deposit (CD) and How It Can Help You Save?

Certificates of deposits (CDs) are savings accounts where you agree to keep money in for a specified time and avoid early withdrawal penalties.

Certificate of Deposit -CD

     FinanceMonies's Key Takeaways:

•  A certificate of deposit (CD) ensures regular returns and is considered a safe investment over the agreed period.
• CD is considered a safe investment option for conservative investors who do not like volatile stock market securities like stocks and bonds.
• Every bank, credit union, and brokerage firm offers competitive CD options.
• Unlike saving accounts, CDs charge financial penalties for premature CDs-early withdrawal penalty (EWP).

    ★What Is a Certificate of Deposit (CD)?    

A certificate of deposit (CD) is a low-risk savings tool that banks and credit unions maintain. CDs are insured by Federal Insurance Corporations for up to $ 250,000. 

It offers a higher rate of returns than any standard savings account in exchange for giving up the withdrawal flexibility for a specific period. 

Banks and credit unions provide unique types of certificates of deposit (CD) for potential investors with competitive rates of returns over a period. CDs are non-volatile, bear low risks, and are interest-guaranteed compared to stocks, and bonds.

    ★Understanding Certificates of Deposit (CDs)

While opening a CD account, you can expect a higher interest rate than a standard savings account. The main difference between a CD account and any conventional savings account is the constraint over the money withdrawals in a CD account until the maturity date comes.

 In an emergency, withdrawals from the CD account can occur at the cost of earned interest. The minimum fee, in the form of a penalty, is charged by the bank or credit union according to the agreement signed at the time of the initial deposit of the CD account. The life of a CD ends when it matures. 

Many banks and credit unions offer the roll of the fully matured amount, including principal and interest amount, in a new CD account on the same terms and conditions with different periods 1 year, 2 years, or a paper check dispatched to the home address or transfer the whole amount into other bank accounts. A complete understanding of the CD process requires five points.

    1) The Institutions: 

You can open a CD account with banks, credit unions, and brokerage firms offering many CD options. Federal Insurance Corporation (FDIC) is a government official that provides deposit insurance for savings and commercial banks in America. The main purpose of this corporation is to build and restore the trust factor in the banking system. So, CDs are FDIC-insured.

    2) The principal amount: 

This is the opening amount of the deposit at the start of the CD term. It is the lump sum money to start your CD journey with some exceptional cases for special CDs.

    3) The term:

This is the fixed term from the CD's principal amount deposit to the CD's maturity date, preventing you from an early withdrawal penalty (EWP). The term can be from one month to five years or more (for example, 6-month CDs, 1-Year CDs, 18-month CDs). At the time of the CD's maturity, you can withdraw your full amount to another bank account, reinvest in any CDs, or receive a paper cheque.

    4) The interest rate: 

It is the rate of returns on CD investment. Many CDs offer fixed interest rates and others variable interest rates. If you lock in a fixed interest rate, you might lose the increased rate potential if it increases in the future. A fixed interest rate lets you know the exact amounts to receive at the CD maturity. 

    5) Early withdrawal penalties (EWPs):

This is a monetary loss on the early withdrawals of money before the term is closed. Read carefully the CD's disclosure agreement and compare it with other options.

Normally, the bank or credit union that manages your CDs, will send electronic monthly or quarterly statements to your designated address. It will include the interest earned and the accumulated balance ( compounded interest + principal amount).

    ★Why Choose a CD and How Can a CD Help You Save?

It will answer why you should open a CD account?. It can help you to achieve your financial goals. CDs are an excellent investment choice with low risks, are federally insured up to $ 250,000, and offer safe and fixed interest rates. 

Mostly, risk-averse investors prefer CDs without taking much risk on their savings. CDs encourage a disciplined investment opportunity as before terms mature, you can't withdraw savings on a CD. Here are how a CD can help you save achieving your financial goals.

    1) Guaranteed Returns:

 CDs provide a predictable and stable return on investment, making them a safe choice for conservative investors. A fixed interest rate CD predicts the returns and how much you will receive at maturity. In contrast to stocks, and mutual funds, CDs are not affected by market fluctuations.

    2) Higher Interest Rates:

Compared to regular savings accounts, CDs offer higher interest rates due to longer terms that can significantly boost savings.

    3) Safety and Security:

 CDs are safe investments insured by FDIC. This insurance means your money is saved even if a bank or credit insurance fails, FDIC provides security and return on CDs while preserving capital.

    4) Encourages Savings Discipline: 

CDs encourage disciplined saving by committing to keep savings untouched until maturity and early withdrawal incurs the penalty and helps to build a more substantial savings over time.

    5) Flexible Terms Option: 

CDs come in a variety of terms, allowing you to choose a term that aligns with your money savings tips for better financial goals and come in a variety of terms, allowing you to choose a term that aligns with your savings goals for Short-Term and medium Term Goals.

    6) Part of Diversified Investment Strategies:

CDs can help Diversifying Your Investment Portfolio and provide a steady income stream in uncertain economic conditions.

In summary, CDs can help you achieve financial goals by providing guaranteed returns, higher interest rates, and safety.

    ★CDs vs. Savings and Money Market Accounts

CDs are similar to savings or money market accounts in that they allow you to put money away for specific goals such as the purchase of a new house, or car or just save money that you do not need, and earn a guaranteed return, but require one initial deposit and pay higher interest rates than any standard savings account. 

But CDs require a fixed period of depositing money, while savings and money market accounts allow withdrawals anytime. So, this liquidity makes savings accounts the best investment opportunity. Both help the investor achieve financial goals -wealth accumulation over a longer time run.

    ★How Are CD Rates Determined?

Federal Reserve's rate-setting decisions affect savings rates.[1]. It's important to shop around and compare CD interest rates before making a decision. 

In a year, the Federal Open Market Committee (FOMC) holds eight scheduled meetings to review economic and financial conditions to determine monetary policy. Every 5 to 7 weeks, the FOMC decides whether to increase, decrease, or remain the same federal interest rate.

So, the Fed's decision on interest rate determination directly affects the interest cost for banks or credit unions. Here is how it works.

Financial institutions treat the Fed's rate as a benchmark rate while keeping in mind other factors like institutional financial policies, market conditions, and other key economic factors. When the Fed's rate goes up, the rate on savings and CDs also rises and vice versa. 

The Feds Reserve system utilizes three monetary policy tools- open market operations, discount rate, and reserve requirement and the Federal Open Market Committee (FOMC) is responsible for open market operations. 

FOMC's operations affect the federal fund rate. It is the interest rate used to lend balances to other depository institutions overnight.

    ★Movements in Fed’s Rates

Changes in federal funds rate generate a series of events affecting foreign exchange rates, short-term interest rates, long-term interest rates, level of money and credit, and key economic variables-employment, commodity output, and price levels of goods and services. 

The Federal Reserve established a near-zero federal funds rate in 2008 to make the US economy lift strength. The Fed did the same thing on 16 March 2020 with a 100-point decrease in the federal interest rate and maintained at 0-0.25 (level %). 

In 2019, the Fed used overnight repurchase agreements (repos) to ensure reserve supply under control and mitigate market pressures resulting from policy implementation. Amid COVID stress in March 2020, the Fed provided continued offers of overnight repos to ensure adequate reserves for short-term U.S. dollar funding markets.

Beyond the Fed's actions, credit unions or banks' willingness to pay on CDs is determined by their lending business approach, deposit reserves, and willingness and competitive ability to attract deposit customers.

    ★Are CDs Safe?

CDs are safe, but only as safe as the financial institution. But it is considered a safe investment instrument due to two reasons. 

The first is a fixed and guaranteed rate with no risk of fluctuation. The second is CD investments are insured by the Federal Deposit Insurance Corporation (FDIC) for bank insurance and the National Credit Union Administration ( NCUA) for credit union insurance.

A bank-offered CD insured by the FDIC protects depositors by up to $ 250,000 or $ 250,000 individually for joint accounts, meanwhile, an NCUA-insured CD with the credit union is by up to $ 250,000.[2],[3]. Additionally, In case of normal default, FDIC insurance does not cover non-deposit investment products or non-FDIC-insured institutions. 

The main key to ensuring CD's funds are in a safe hand is choosing an institution with FDIC or NCUA insurance and avoiding exceeding $250,000 in deposits in one name -you can open with your partner's name. Spread funds across multiple institutions for risk mitigation.

    ★When Is Opening a CD a Good Idea?

CDs are suitable investments for short-term needs, such as buying new houses or new cars. You may want simply invest conservatively or avoid the risk and volatility of the stock market or bond market. The most important feature is CDs offer growth potential but don't carry downturn risk.

    ★Where Can I Get a CD?

 Banks and credit unions offer a variety of CDs. A brokerage account can also serve as a middleman for opening CDs. 

Large banks including Bank of America, and Wells Fargo provide a competitive series of CD terms and rates. Community banks are Smaller, local banks that offer personalized service. 

Credit unions including Navy Federal Credit Union, and Alliant Credit Union; Brokerage firms including Charles Schwab, Fidelity, and TD Ameritrade also provide competitive rates for CDs. 

    ★Shop Around to Find the Top CD Rates

When opening a CD account, finding the right CD requires finding a financially stable institution. Online banking has enabled customers to shop for CDs at hundreds of banks and credit unions nationwide. 

It gives access to regional and state banks and credit unions based on residency. Rates vary widely, so comparing rates with other institutions is important.

    ★How Much Do I Need to Open a CD?

The amount needed to open a CD varies depending on the financial institution's policy and the relevant CD terms. Banks and credit unions set minimum deposits to open CDs, with some offering higher annual percentage yield (APY) on different levels of minimum deposits for a unique tier range of CDs. 

A typical certificate of deposit requires a minimum deposit of $500-2,500 or more and some have no minimum balance requirements.

    ★Which CD Term Should I Choose?

CD term selection depends on financial goals, interest rate environment, and liquidity needs. Long-term CDs can be beneficial for long-term goals due to higher interest rates such as house down payment, and retirements. 

CDs with higher minimum deposits offer higher APYs, such as jumbo CDs requiring a minimum deposit of $ 100,000 or more, and bump-up or step-up CDs allow to adjust the interest rate over the CD's term. 

Short- and mid-term CDs make more sense if the Fed's rates are expected to rise, while long-term CDs make more sense if rates decrease in the near term. 

So, you can intelligently lock your investment for years to come. 

    ★What Is a CD Ladder, and Why Should I Build One?

Smart CD investors use hedging strategies to maximize returns. CD Ladder includes dividing your funds into multiple CDs with various maturity dates. 

The CD ladder allows access to higher rates with a portion of money available every year.

 Here is an example of investing a $10,000 fund, divided over a 5-year term plan, each part earning 5% per annum interest to build a CD Ladder. Divide $10,000 into 5 equal parts of $2,000. Invest each part in CDs with different maturity periods (1-year, 2-year, 3-year, 4-year, 5-year) and then the maturing amount from each CD to reinvest into a 5-year  CD. 

This will place you in a position to receive the final maturing amount every 12 months, and more access to your funds.

    CD Ladder Example:

Year    Initial Investment Interest Earned(at 5%) Total at Maturity Reinvestment

0    $2,000 (1-year CD)     $100                  $2,100       Reinvest in a new 5-year CD

0    $2,000 (2-year CD)     $200                            $2,200       Reinvest in a new 5-year CD

0    $2,000 (3-year CD)     $300                             $2,300      Reinvest in a new 5-year CD

0    $2,000 (4-year CD)     $400                             $2,400      Reinvest in a new 5-year CD

0    $2,000 (5-year CD)     $500                             $2,500      Reinvest in a new 5-year CD

Notes:

• Interest is compounded annually.
• The table assumes reinvestment at the same 5% interest rate for simplicity.
• Actual returns will vary based on interest rate changes and the specific terms of the CDs.

    ★How Are CD Earnings Taxed?

Interest is a taxable income in the year it is available. Interest earned on CDs is credited either monthly or quarterly into the account and you will treat it as interest income earned into your tax returns.[4]. 

There is one thing confusing regarding funds being available only, and you can't make withdrawals for consumption till the maturity date -Is there a need to show this in your tax returns?. The answer is Yes!.CDs are taxable upon funds available over a bank account, regardless of CD funds withdrawal [5].

    ★What Happens to My CD at Maturity?

When the term is complete, the CD gets maturity. The bank or credit union communicates in a written way the maturing date with grace days to decide what to do with the maturing amount including the accumulated interest income earned. 

Different institutions in the US offer 1 week or 10 days as grace days. Typically, you will receive three following options once your CD matures.

    1) Withdrawal, Transfer of the maturing funds:

You can choose the transfer of principal and interest to any external bank account, take it as a paper or electronic check; or transfer funds to the same bank accounts-savings accounts etc.

    2) Roll the CD over into a new CD at that bank or credit union:

 Generally, you might decide to roll over the CDs in the same bank or credit union if matched to the term of the maturing CD and your financial goals.

    3) Reinvest in Other Multiple Financial Products: 

You may choose other investment vehicles. Investing funds in other financial products such as a CD with higher interest rates, a savings account, a money market account, or other multiple financial products.

    ★Should I Let My CD Roll Over?

Rolling over a CD into a similar term at the same institution is not recommended for maximum return. Shopping around is necessary to get the best rate on CD investments, even if the bank where the CD is maturing is a top contestant. 

You can decide whether to roll over your CD based on your financial goals and market conditions. Consider exploring new investment options or opting for a safe and predictable return. If possible, consult with a financial advisor before making a decision.

    

★What If I Need to Withdraw My Money Early?

Banks and credit unions have laid down terms for how to cash out a CD. Early withdrawal penalties (EWPs) are assessed on the proceeds before the funds are matured. 

The EWP is charged as several months' interest, with a greater number for longer CD terms. You can make funds withdraw if found other lucrative investment opportunities. It is important to compare the EWP policies of banks or credit unions when deciding between two similar CDs.

You may lose 3 months of interest if the CD matures within 6 months or less; may lose 12 months of interest earned on a CD that matures within 5 years in case of early withdrawals before the maturity date. EWPs can eat into your principal amount, but some particularly onerous penalties exist in the marketplace. 

    

    ★How Do You Find the Best CD Rates?

It takes a lot of research to find the best CD rates. You can find the best CD rates in the following way. 

• Use financial websites and comparison tools to find the latest CD rates from banks and credit unions.
• Look beyond the interest rate and compare terms and conditions.
• Further, a list is available based on the length of time available.

1. Best Jumbo CD Rates
2. Best 3-Month CD Rates
3. Best 6-Month CD Rates
4. Best 1-Year CD Rates
5. Best 2-Year CD Rates
6. Best 3- Year CD Rates
7. Best 4-Year CD Rates
8. Best 5-Year CD Rates

    ★How Does a Certificate of Deposit (CD) Work?

CDs are one of the most popular savings vehicles, provided by banks and credit unions. Depositors put money on deposit for a fixed period, and the bank pays a higher interest rate based on the federal funds rate and CD agreement. 

When the CD term is mature, the original investment plus interest cumulatively is received.

    ★ Can You Lose Money on a CD?

Normally, it is believed that losing money on a CD is almost zero chance. First, it is guaranteed by banks or credit unions, and second, it is insured by the federal government up to $ 250,000. [6],[7]

    

    ★What Are the Advantages and Disadvantages of a CD?

Some savers prefer CDs for their safety and return predictability, while others prefer them for their modest rate of return. Many yield-conscious investors prefer CDs over riskier investments like stocks and bonds because they offer higher potential returns. 

Disadvantages of CDs are limited liquidity, opportunity cost, inflation risk, and lower returns compared to other investments.

Certificates of deposit offer stability with higher interest rates than stocks and bonds, but require careful reading. Long terms may not guarantee higher returns and early withdrawal has penalties. Knowing the limitations and benefits before investing could be the best money management decision.