What Is a Certificate Of Deposit?
A Certificate of Deposit (CD) is a financial product offered by banks and credit unions that allows you to invest a fixed amount of money for a set period, typically ranging from a few months to several years. In exchange for locking up your money for the specified term, the financial institution pays you a fixed interest rate that is typically higher than what you would earn in a regular savings account.
CDs are considered a low-risk investment because they are insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000 per depositor, per institution. This means that even if the bank or credit union fails, your investment is protected.
CDs usually have a penalty for early withdrawal before the end of the term, which means you will lose some or all of the interest you would have earned if you withdraw the money before the time is up. However, if you don’t need access to the funds for the specified period, CDs can be an excellent way to earn a guaranteed return on your investment.
National Average Interest Rates For CDs
By researching average interest rates, you can gain valuable insights into the current CD rate landscape and potentially identify CDs with yields that surpass the average. As of the week of Feb. 15, 2023, Fintechaffair’s weekly survey of institutions reports the following average rates:
| CD term | CD national average APY |
| 1 year | 1.52% |
| 2 year | 1.35% |
| 3 year | 1.16% |
| 4 year | 1.16% |
| 5 year | 1.18% |
Note: Average APYs are shown. See the table at the top of the page for APY comparisons.
How to Choose a Certificate of Deposit (CD)
If you have longer-term financial goals or money that you’re comfortable putting away for a specific period, a CD can be a smart choice. To select the right CD for your needs, follow these steps:
- Determine the purpose of the funds. If the money is intended for an emergency fund, a short-term goal, or if you’re uncertain when you’ll need it, a high-yield savings account or money market account may be a better fit. You might also want to consider a no-penalty A Certificate of Deposit.
- Determine the timeline for when the money will be needed, and assess your risk tolerance. Money that must be kept secure and cannot be lost should generally be placed in an account that is backed by the Federal Deposit Insurance Corporation (FDIC) and adheres to FDIC guidelines and limits.
- Select a CD term that aligns with your savings goals. CD terms can range from just a few months to several years.
- Shop around and compare rates. Research various banks and credit unions to find the best rates, and ensure that the minimum opening deposit aligns with the amount you plan to invest. Typically, online banks offer the highest rates, but brick-and-mortar banks or credit unions can also provide a competitive yield.
- Open the Certificate of Deposit (CD) account and deposit the funds.
Explain What A CD Is And How It Operates?
A CD, or certificate of deposit, is an account banks and credit unions provide that pays interest on a deposit for a predetermined period. Typically, CDs offer a guaranteed fixed rate of return throughout the term. The interest rate generally increases with the duration of the CD term or the length of time that the money is held, but early withdrawal from the CD will often incur a penalty.
Types of CDs
Financial institutions offer a wide range of CDs to fit different financial situations. Take time to consider which type of CD is best for you.
Traditional CDs
The most widespread type of CD is the traditional CD, which provides a fixed APY for the term of the CD. With these CDs, depositing additional funds before maturity is often prohibited, and there are typically severe early withdrawal penalties.
In what scenarios is this CD a suitable option?
This type of CD is suitable in situations where you have a precise date in mind for when you’ll require the funds and there’s no possibility of needing them earlier. It’s an excellent option for CD laddering or other investment strategies that rely on timing.
No-Penalty CDs
Traditionally, CDs are categorized as time deposit accounts, meaning that an early withdrawal from a CD typically results in a penalty equivalent to a specific portion of the interest earned over a defined period. For example, if you withdraw from a one-year CD before its maturity, a bank may levy a penalty of 90 days of simple interest. However, some banks offer no-penalty CDs, also known as liquid CDs, which enable you to withdraw your funds early without incurring a penalty fee that could impact your interest earnings.
Some banks may require a waiting period, typically around six or seven days, before you’re permitted to withdraw funds from a no-penalty CD, and partial withdrawals may not be permitted by some banks. While the rates for no-penalty CDs are usually lower than standard CDs, they can be higher than those for some high-yield savings accounts or money market accounts.
In what scenarios is this CD a suitable option?
Although you’re most confident that you won’t need to withdraw the money before the CD reaches maturity, you want to maintain some flexibility in case you do need to access it. Therefore, you’re willing to sacrifice a small amount of return in exchange for increased liquidity.
Bump-Up CDs
With a bump-up CD, you have the option to request a higher interest rate under certain conditions during the CD’s term, but most financial institutions only permit one rate increase per term. For instance, suppose you buy a three-year CD at a specific rate and the bank offers an extra half-point increase one year into the term. In that case, you can request a rate boost for the remaining term with this type of CD. However, the downside is that bump-up CDs often offer lower initial rates than traditional CDs.
In what scenarios is this CD a suitable option?
If you anticipate a significant rise in interest rates during the CD term, a bump-up CD may be a viable choice. Otherwise, you may be settling for a lower rate with limited potential for gains.
Is it safe to Invest in CDs?
As long as you stay within the insurance guidelines, CDs held at either an FDIC-insured bank or a credit union regulated by the NCUA and insured by the NCUSIF are safe. These accounts, whether held at online or brick-and-mortar banks or credit unions, are fully guaranteed by the U.S. government.
It’s essential to ensure that you’re not exceeding the insurance limits, which are set at $250,000 per depositor, per insured bank, for each account ownership category at an FDIC-insured bank, and $250,000 per share owner, per insured credit union, for each account ownership category at a federally insured credit union.
Who would benefit from opening a CD?
Individuals seeking a secure and guaranteed return on their cash may want to consider opening a CD. CDs can be a suitable and low-risk investment option for achieving short- to medium-term goals, such as saving for a down payment on a home or a new car.
The following people may find a CD to be a worthwhile investment:
- Those with specific timelines in mind: For someone with a two-year savings goal, an 18-month CD could be a viable option. However, it’s important to ensure that you won’t need the money during the CD term, or else you may face costly penalties for early withdrawal.
- Risk-averse investors: Instead of speculating on future savings account yields, you can accurately calculate your interest earnings upfront with a CD.
- Individuals prone to impulsive spending: A CD, with its early withdrawal penalty, can discourage you from dipping into your savings before the CD term ends.
Advantages and Disadvantages of CDs.
Before selecting a CD, it’s essential to evaluate the advantages and disadvantages to determine the best investment decision for your financial circumstances. You should consider factors such as the interest rate, the frequency of interest compounding, and whether you prefer a CD from an online bank or a traditional institution with physical branches.
Below are some of the advantages and disadvantages of CDs:
Advantages:
- Longer-term CDs typically offer a higher APY compared to savings accounts or money market accounts.
- CDs provide a secure location to save money that you don’t want to spend easily.
- CDs can aid in segregating funds for financial goals or future expenditures.
- Deposit insurance protects FDIC bank accounts up to at least $250,000 and federally insures your funds to at least $250,000 at an NCUA credit union.
- CDs can diversify your savings strategy with a fixed rate of return.
- As long as you maintain your funds in a CD for the full term, your principal is safe.
Disadvantages:
- Your funds remain in a CD for a potentially extended duration.
- Several CDs incur penalties for early withdrawal.
- If interest rates increase significantly, your funds may be stuck in a lower-yielding CD. Additionally, the early withdrawal penalty may offset the benefits of transferring to a higher-yielding CD.
- There’s a possibility of earning higher returns in the stock market or by investing in other securities.
The Federal Reserve and Certificate of Deposit Rates
The rates offered by banks on CDs can be influenced by the Federal Reserve’s decisions regarding interest rates. Typically, when the Fed raises or lowers the federal funds rate, banks adjust their savings and money market account yields in a similar direction. CDs, which tend to closely follow Treasuries, are also affected. In 2019, when the Fed lowered rates three times, CDs generally decreased before or after the rate cut.
In March 2020, due to two emergency rate cuts by the Fed and decreasing Treasuries, high-yield CDs experienced a decline.
In 2022, the U.S. central bank raised rates several times to combat inflation, and in February 2023, the Fed raised rates again. Even before the Fed’s first move in March 2022, some banks offering competitive yields began to provide higher APYs on CDs.
Will there be an increase in CD Rates?
CD rates have been on the rise for much of the year, and there are a couple of key factors driving this trend. One is the Federal Reserve, whose policies can impact not only savings account rates but also CD rates. As the Fed has continued to increase rates, banks have been compelled to offer higher CD annual percentage yields (APYs) to stay competitive and entice customers to deposit their funds.
Overall, the combination of these two factors has led to a significant uptick in Certificate of Deposit rates across the country.
Certificate of Deposit vs. other Savings Accounts
Certificate of Deposit vs. Traditional Savings Accounts
Compared to CDs, savings and money market accounts are more readily accessible and entail fewer withdrawal restrictions or penalties. As such, these accounts are ideal for emergency funds that require prompt access to cash. While it’s possible to withdraw funds from a CD before its maturity date, doing so may incur a penalty fee unless you have opted for a no-penalty CD.
Therefore, if you prioritize liquidity and flexibility in your savings, a savings or money market account would be a more suitable option than a Certificate of Deposit.
Certificate of Deposit vs. High-Yield Savings Accounts
It’s not uncommon to find a one-year Certificate of Deposit at certain banks with a higher annual percentage yield (APY) compared to a high-yield savings account. However, there are key differences between these two financial products.
Firstly, high-yield savings accounts tend to be more liquid, meaning that you can typically withdraw money without incurring a fee. In contrast, CDs often have early withdrawal penalties. Note that some savings accounts may charge a fee if you exceed a certain number of withdrawals within a monthly statement cycle, and there may also be an early closeout fee for some accounts.
Secondly, high-yield savings accounts typically offer variable APYs, meaning that the rate may fluctuate over time. By contrast, CDs typically have a fixed APY for the term of the account.
Therefore, if you prioritize flexibility and accessibility in your savings, a high-yield savings account may be a better option than a CD, even if the latter has a higher APY. On the other hand, if you’re comfortable locking in your funds for a set period and prefer a guaranteed return, a CD with a higher fixed APY may be a more suitable choice.
Certificate of Deposit vs. Money Market Accounts
The difference in interest rates between CDs and savings accounts has become smaller, but CDs still tend to offer a higher yield than savings accounts or money market accounts.
Both CDs and money market accounts are savings products that banks and credit unions provide, and they are generally considered safe if they are insured by the FDIC at banks or the NCUSIF at credit unions. However, savers opening a CD or money market account may need to meet higher minimum deposit requirements than they would with a savings account.
While CDs and money market account share some similarities, there are notable differences. Money market accounts tend to offer more liquidity than CDs, often allowing a limited number of checks per month or even a debit card. These liquidity features are not typically available with CDs. However, in exchange for less liquidity, CDs typically offer a higher interest rate compared to money market accounts.
Certificate of Deposit vs. Bonds
When considering whether to invest in a Certificate of Deposit or a bond, investors have several factors to weigh. Traditional CDs from banks are FDIC-insured or insured by the National Credit Union Administration (NCUA) Share Insurance Fund if obtained from an NCUA credit union.
CDs are generally considered a safe investment that provides a fixed interest rate, so investors know upfront how much they’ll earn. Additionally, if investors do not make any early withdrawals, they’re guaranteed to receive their full principal amount plus interest at the end of the term.
However, if investors want more flexibility and the chance to earn a higher yield, they may want to explore investing in a bond. Bonds involve loaning money to a government or corporation and receiving a rate of return.
Although investors can sell a bond before it matures without incurring an early withdrawal penalty, the value received may be more or less than the original investment if interest rates have changed. Moreover, the interest earned from municipal bonds is often tax-exempt.
It’s essential to keep in mind that there are many different types of bonds, and some are riskier than others. Bonds are not insured by the FDIC or NCUSIF like CDs are, and their value may vary depending on market conditions.
Certificate of Deposit and Taxes
Are you taxed on a Certificate of deposit when it matures?
When earning interest on a CD that contains non-qualified money, which refers to money that has already been taxed, you will be subject to taxes. However, if the funds are in a traditional IRA CD, you will pay taxes upon withdrawal because traditional IRAs are tax-deferred accounts.
In some situations, you may be able to deduct your CD from your taxes. If you’re eligible to contribute to a traditional IRA CD, you might qualify for a full deduction up to your contribution limit, or a partial deduction. Your eligibility for an IRA deduction depends on various factors, such as your modified adjusted gross income, marital status, and whether you’re covered by a retirement plan at work.
Does Cashing a Certificate of Deposit Count as Income?
The Internal Revenue Service considers interest earned from CDs as taxable interest. If your interest earnings from a CD are $10 or more, you should expect to receive Copy B of Form 1099-INT or Form 1099-OID. However, even if you don’t receive 1099, all taxable and tax-exempt interest must be reported on your federal income tax return.
Sometimes, interest earned from CDs may be referred to as dividends. An exception to this rule would be if the funds were rolled over from a 401(k) into a traditional IRA CD, and those funds have never been taxed. In such a situation, if you withdraw from a traditional IRA CD, the amount you withdraw will count as income and will be subject to taxation.
How to Build a Certificate of Deposit Ladder
Certificate of Deposit laddering is an investment strategy where you buy multiple CDs with different maturity dates to space out when the money is available and take advantage of higher rates on longer-term CDs. By diversifying over a range of maturity dates, you can reinvest at consistent intervals and receive a regular stream of interest income.
According to Fintechaffair’s Financial Analyst, “Looking for a regular stream of interest income? Consider a CD ladder where your money is diversified over a range of maturity dates, structured so you get to reinvest at consistent intervals.”
Typically, longer CD terms offer higher yields, but locking up all your money in a long-term CD can be risky if interest rates rise. With a CD ladder, you can mitigate that risk by investing in shorter-term CDs that mature within a shorter period, like six months or one year, and longer-term CDs with higher yields.
For example, with $15,000 to invest, you could create a CD laddering plan with three CDs, each with a different term length:
- $5,000 in a one-year CD
- $5,000 in a two-year CD
- $5,000 in a three-year CD
This way, you can earn higher interest rates on the longer-term Certificate of Deposit while still having access to some of your money every year as the shorter-term CDs mature.
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