Certificates of deposit: How they work to grow your money

Learn how this savings tool works, when to consider it and your options.

Tags: Budgeting, Goals, Savings
Published: March 18, 2020

You probably already have a checking or savings account from which you pay monthly bills and cover daily expenses. You might even have a retirement savings account like a 401k or IRA. If you also have some extra money that you won’t need right away, consider growing it with a certificate of deposit (CD). A CD may  give you a higher return than a traditional savings account, while still allowing you to withdraw your money after a set period of time that you select when you open the account.
 

How do CDs work?

A certificate of deposit is a type of savings account that you agree to keep your money in for a certain amount of time, known as the term. The term could be three or six months, one year or longer.

Here are some key things to know if you are considering a CD:


Opening a CD:
Usually you’ll have to deposit a minimum amount of money. This could be $250 or $500, or up to thousands of dollars. Some CDs have no minimum opening deposit.


Interest:
Once you deposit your money in a CD account, the bank knows it will have your money available for the term to make loans or for other uses. The bank pays you interest for your commitment. Interest payments vary, and if you purchase a one-year CD the interest you earn may be added in a single payment at the end of the year. Or, some of the interest may be added to your account each day or month.

Pay attention to how interest accumulates. If your money gains interest daily, you’ll earn more interest over time than if interest is only added yearly. The rate at which interest is added can be different than the rate at which it’s paid, so it’s important to read the terms closely. Your bank will tell you how much interest you will earn by giving you an annual percentage yield, or APY. This APY helps you compare different CD options.


Time:
In exchange for agreeing to leave your money in the account for the full term, you’ll earn a higher interest rate than you would with a traditional savings account or a checking account. Typically, the longer you leave money in an account that pays interest, the more money you make. You may get higher interest rates on longer-term CDs than on short-term ones.

 

How percentage yield works graphic


Maturity:
Your CD reaches maturity at the end of the term you chose when you opened the account. Then, either you can withdraw the money, or you can reinvest in another CD. If you do nothing, a bank typically will automatically reinvest your money in another CD with the same term. If you want to withdraw your money or move it into a CD with a longer or shorter term, you’ll need to let the bank know during the grace period of the CD. This is a period of time after the CD matures during which you can make changes to your account with no penalty. Then, you can transfer your deposit to your checking or savings account, or you can purchase another CD with a different term.


Early withdrawal:
If you withdraw money before the CD’s term ends, you’ll usually have to pay a penalty. This penalty varies, but you may have to give up some of your interest earnings – sometimes as much as three or six months’ worth.


Laddering:
Many savers may try to take advantage of the higher interest rates CDs tend to offer while also attempting to keep their savings semi liquid. They often do this by purchasing more than one CD. For example, you might deposit money in a one-year, two-year, three-year, four-year and five-year CD — a strategy known as laddering. With this approach, one CD would mature each year, and you would be able to access the original funds and earned interest without paying a penalty. This also may be a valuable approach if interest rates rise more generally throughout the economy. When interest rates increase broadly, you are likely to earn a higher interest rate on a new CD account.1


When should you consider a CD?

CDs may be a good choice if you have budgeted well and have some money in savings that you’re unlikely to need right away. Consider other CD pros:

  • Low-risk investment: CDs from banks are generally FDIC insured, that is insured by the Federal Deposit Insurance Corporation. If your bank participates, your CD deposit generally is protected up to $250,000, making CDs a safer investment than stocks, which are not insured against loss of principal.
  • Savings motivation: When you open a CD account, the penalty for withdrawing your deposit before the term ends can be a strong incentive not to spend money you planned to save. If you want to add extra protection to your savings goals, a CD may be a good option. While CD accounts are less common than checking or savings accounts, households with CDs tend to hold a lot more money in them than they do in checking or savings, according to the Federal Reserve.
     

When is a CD not right for you?

If you are uncertain about your spending plans for the next few months or years, or if you will need to take money out of savings soon for a major purchase, a CD may not be the best choice. The penalty for early withdrawal removes some flexibility and value.

Additionally, they are not a good substitute for a broader strategy to invest for retirement, because they generally earn lower interest rates relative to other options, such as purchasing stocks, bonds or mutual funds. That means it can be harder to use CDs to accumulate the funds you will need for retirement.

 

 

Types of accounts by household  - graphic


What types of CDs are available?

Traditional CDs: These CD accounts are the most common and have fixed interest rates and terms. This means the interest rate and length of time you will keep your deposit in the account are set when you make the initial deposit, and they won’t change until the CD matures. Traditional CDs also require you to pay a penalty if you withdraw your money before the account matures. But there are other types of CDs with different terms that could be a good fit for your savings plans.


Trade-up CD:
This type of CD offers a lower interest rate at the beginning of its term than a traditional CD does. However, it also gives you an opportunity to earn more. If interest rates rise on CDs with similar terms before your CD matures, you can choose to raise the interest rate of your account at least once during the term. If rates don’t rise, however, you could miss out on the higher interest rates offered by traditional CDs. A trade-up CD could be a good choice if you expect interest rates to increase soon.


Step-up CD:
Like most CDs, a step-up CD has a set interest rate at the beginning of its term. A step-up CD also typically starts with a lower interest rate than a traditional CD with a similar term. But unlike other CDs, the rate on a step-up CD rises at specific stages over the life of the CD. For example, in a 28-month CD, the interest rate might rise after seven, 14 and 21 months. A step-up CD may be a useful option if you expect interest rates to rise, but you are concerned about having to choose the best time to increase the rate, as you would with a trade-up CD.


No-penalty CD:
Suppose that you are interested in purchasing a CD, but you’re unsure about whether you may need the money before the CD term ends. A no-penalty CD, as its name suggests, does not require you to pay a penalty if you withdraw your money before the account matures. The tradeoff is that this type of CD generally offers a lower interest rate than that of a traditional CD, which do have a penalty for early withdrawal.


CDs can be part of a sound financial plan. To learn which kinds of CDs might be best for you, speak with your banker or accountant.

 

Ready to save?  Start by comparing potential rates for U.S. Bank CDs today.
 



1
”What is a CD Ladder?” NerdWallet, November 2018.

The customer would need to do this within what is called “grace period”; in which per regulations bank’s must notify a customer a specific amount of days ahead of time before the maturity date, so that once the account matures the customer is aware that they have a grace period (typically 10 days) to decide what to do (withdraw money without a penalty, renew CD or purchase a new CD).