What is Certificate of Deposit (COD)?

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Definition:

A Certificate of Deposit is a special type of bank account that typically pays higher rates of interest in exchange for your promise to not withdraw money for a set period.

🤔 Understanding the Certificate of Deposit

When you open a Certificate of Deposit (CD), you promise to leave the funds in the CD untouched for a set period, known as the CD’s term. In exchange for this promise, banks generally pay higher interest rates to CD holders than to customers with savings accounts. If you break this promise and make an early withdrawal, the bank will deduct a penalty from the amount that you withdraw. The most common CD terms are six, 12, 24, 36, and 60 months.

Example

Suppose that John goes to his local bank to open an account. The savings accounts may offer 1% interest annually, but a 1-year CD might offer an interest rate of 1.25%. He decides to open a CD to take advantage of the higher interest rate. After a year, he can withdraw his money without penalty. However, if he has to withdraw part of the investment before the year ends, John might face the consequences. He’ll probably have to pay a fee, which could be as much as six months of the interest returned by the CD, or even more if he wants to get all of his initial deposit back.

Takeaway

A CD is like a bank vault…

You put your money in the vault and give someone else the key. They promise to come back on a specific day with the key, and some additional cash. If you can wait, you’ll receive your money back, plus the contractual interest. If you summon them to open the vault early, they’ll be annoyed, and will fine you for making them show up before the agreed-upon date.

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How does a CD work?

When you open a CD, you have to commit to keeping your money in the CD for a set amount of time—the CD’s term. During the life of a CD, you cannot make any additional deposits or withdrawals. If you must make a withdrawal from the CD before its term ends, you will pay a penalty. Usually, the penalty is calculated based on the amount of your daily interest. Larger CDs tend to charge higher fees for early withdrawals.

For example, on Oct. 16th, 2019, Ally Bank was offering a 12-month CD with a return of 2.15%. Its early withdrawal penalty was equal to two months of interest. If you initially invested $10,000, you would have earned $217.32 in interest during the 12-month period. However, if you withdrew funds after nine months, you would have only earned $162.55 in interest. Unfortunately, the penalty would further reduce your earnings to $126.20 after the last 60 days of interest are deducted.

In exchange for committing to keep your money in the account for a set period, CDs usually have higher interest rates than other deposit accounts. When your CD’s term ends, the principal, plus all of the interest that you earned, can be withdrawn. At this time, you can also opt to add more money to the CD. If you take no action, most banks will roll your balance into a new CD with the same term as the previous one. If this happens, you can’t make a withdrawal without waiting until the new CD’s term ends. Once again, if you must make an early withdrawal, the bank will charge a fee. To give you a fair chance to make changes, most banks will notify you shortly before your CD matures.

What are the benefits and risks? Are CDs worth it?

One benefit of a CD as compared to securities like bonds or stocks is that the Federal Deposit Insurance Corp. (FDIC) offers insurance for CDs. If the bank holding your CD fails, the FDIC will reimburse you for up to $250,000 in losses. In contrast, equities or bonds lack similar insurance if they decline in value.

CDs also typically offer higher interest rates than traditional savings accounts. If you know that you won’t need to make a withdrawal for a certain period, a CD can potentially help you earn more interest.

The main risk of opening a CD is interest rate risk. The interest rate that the CD earns is set when you open the CD. If interest rates rise during the life of the CD, your investment will continue to receive the lower, original rate. Conversely, if rates drop, the CD will continue to earn the higher rate, making this both a risk and a potential benefit.

How much do I need to open a CD?

The minimum amount that you need to open a CD varies from bank to bank. Some banks or credit unions have CD minimums of $1,000 or more; others have no minimum deposit requirements. If you search around, you’ll likely find a bank that offers a CD that you can open, regardless of your budget.

What CD term should I choose?

The best CD term for you varies with your financial situation and personal goals. One strategy is to time your CD to mature as close as possible to the date that you’ll need access to the cash.

For example, if you know that you want to buy a house in 2022, you should open a three-year CD. This will ensure that you have your money available to you when you start shopping for a house.

Interest rate risk is a concern that should be considered if you’re planning to open a long-term CD. You might want to open a shorter-term CD and deposit the proceeds into another CD instead of opening one long-term CD. This can help you reduce interest rate risk.

What is a CD ladder?

A CD ladder is a strategy that lets you put your savings into multiple CDs in order to manage your overall interest income while increasing the availability to make a withdrawal without paying any early withdrawal fees.

For example, if you have an emergency fund of $12,000, you can divide it into $1,000 portions. Then, open 12 CDs, one with a term of one month, another with a term of two months, a third with a term of three months, and so on.

Every month, one CD will mature, and you have the option to withdraw $1,000. If you don’t need to make a withdrawal, you can roll the balance into a new, one-year CD. Eventually, you will have twelve one-year CDs, with one maturing each month.

This strategy lets you increase your overall interest earnings while mitigating some of the inflexibility of using CDs.

How are CDs taxed?

The interest that you earn from money deposited to CDs is taxed the same way that interest earned from bank accounts is taxed. At year’s end, banks send a form 1099-INT to their customers with information about the interest they’ve earned.

You only have to pay tax on the interest earned in the tax year for which you’re filing. If you open a five-year CD, you won’t pay taxes for all of the interest that you earned when the CD matures. For each of the five years, only the interest that you received that year is taxable.

Keep in mind that you can deduct any early withdrawal penalties that you pay from your interest earnings. This reduces your tax bill if you ever take an early withdrawal.

What happens when a CD matures?

When a CD matures, you get the opportunity to make deposits or withdrawals to the account without penalty. If you make no changes to the account, most banks roll the balance into a new CD with the same term. If that happens, you cannot make withdrawals or changes until the new CD matures.

CDs vs. savings accounts vs. money market accounts?

Savings accounts are designed to provide interest while maintaining flexibility. You can make deposits and withdrawals with few limits.

CDs tend to provide more interest than savings accounts, but you sacrifice flexibility.

Bank money market accounts combine features of checking and savings accounts. These accounts typically offer higher interest rates and more flexibility, such as the option to make debit card purchases or write checks. However, money market accounts have more restrictions than checking accounts, i.e., a limit on the number of monthly transactions. Banks also tend to charge higher fees on these accounts in exchange for their flexibility.

What are specialty CDs?

Some banks offer specialty CDs, such as bump-up CDs, jumbo CDs, and no-penalty CDs. These CDs alter the usual rules for CDs.

For example, bump-up CDs give you the chance to increase your interest rate a set number of times during the CD’s life. This only happens if market rates have increased. The feature can reduce the interest rate risk of a bump-up CD, but usually comes at the cost of a lower initial rate.

No-penalty CDs don’t charge early-withdrawal fees, but tend to have lower interest rates than traditional rates.

Jumbo CDs have high minimum balance requirements. Often, the requirement is $100,000 or more. In exchange for making such a large deposit, jumbo CDs tend to pay more interest than traditional CDs.

What is the CD interest formula?

Calculating how much interest you will earn during the term of your CD is not complicated. In fact, you can calculate the total interest that you’ll earn using the standard compound interest formula. Here is the formula:

Ending balance = P (1 + r/n)nt*

P = principal

r = interest rate as a decimal

n = number of times interest compounds per unit of time

t = number of units of time

If you deposit $10,000 to a five-year CD with a 2% interest rate that compounds interest monthly, you’ll earn:

$10,000 (1 + .02/12)125 = $11,050.79

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