Not to be confused with the CDs you used to burn music onto, the CD (Certificate of Deposit) we’re referring to is a type of savings account.
A Certificate of Deposit is a savings account that typically has higher interest rates than a traditional savings account, and a fixed withdrawal or maturity date.
The trade-off for the higher interest rate is that your cash is less accessible; you agree to leave your money deposited for an agreed amount of time, called the term. If you withdraw your money before the CD matures, you’ll usually have to pay a penalty.
Generally, a CD with a longer term will have a higher interest rate. Because the interest rate, expressed as an APY or annual percentage yield, of a Certificate of Deposit is typically fixed, it won’t change over your term length.
Opening a CD could be a smart option if you are confident that you won’t need the money during the term.
Because CDs vary in type and length, it’s important to choose the one that’s right for you.
There are a variety of types of CDs offered by financial institutions. Some of those include:
As it sounds, a high-yield CD account gives you a higher interest rate compared to a traditional Certificate of Deposit. Of course, this could come with conditions. You may have to either put in more money up front or keep your money tucked away for longer in order to earn a higher interest rate.
However, the interest rate on your CD will also depend on the bank you choose. Online banks, for instance, are often able to offer more competitive rates because they don’t have to pay many of the costs associated with operating a traditional brick-and-mortar shop.
With a bump up Certificate of Deposit account, you have the ability to take advantage of increasing interest rates. When interest rates increase, this type of CD gives you the option to direct the bank to change your interest rate (usually only once) to the current, higher rate offered, for the remainder of your term.
The downside of this type of account is that the initial interest rate offered may be lower than that of typical CDs.
Step up Certificates of Deposit are similar to bump up CDs, but with a step up certificate, your interest rate is automatically adjusted to a predetermined amount at a set time(s).
A liquid Certificate of Deposit differs from a typical CD account because it allows you to withdraw your money without paying a penalty after a certain date, though you may have to maintain an agreed-upon balance in the account. The tradeoff for that convenience is that your interest rate will likely be lower than it is on a typical CD account, but it could still be higher than the interest rate your bank offers on savings accounts.
Also note that the date when you can make your first withdrawal without a penalty is usually set by the financial institution.
A zero coupon Certificate of Deposit is purchased at a lower cost than the face value that you’ll receive when the CD matures. With a zero coupon CD, you won’t receive any periodic interest payments over the life of the CD. Instead, you’ll receive the face value of the CD when it matures, which will include the accrued interest.
For example, if you purchased a 10-year, $100,000 CD for $80,000, you won’t receive any interest on this CD during the 10 year term, but you’ll get the full value of $100,000 at the end of the 10 years (accounting for the interest you waited to receive).
A downside to this type of CD is that even though you’re not receiving your interest payments, you’ll still be taxed annually on the accrued interest (the interest is treated as taxable income).
Since you won’t actually receive the accrued interest until the Certificate of Deposit matures, when you make this type of long-term investment you have to ensure that you will have the money to cover the taxes on the interest earned. Additionally, consider that because these CDs are usually for longer terms, the interest rate risk (the risk that rates will change during your term) is higher.
A callable Certificate of Deposit has something called a call feature; which allows the bank to terminate your CD after a certain period of time.
Basically, when a CD becomes callable the issuing bank can terminate the CD and you’ll receive your full principal and interest earned up to the point at which the bank exercised the call right.
Let’s say you purchase a 3-year Certificate of Deposit with a 6-month call protection period at 3%. After 6 months, the bank can call back your CD. Banks will usually do this if interest rates have fallen and they can issue CDs with lower interest rates.
Your initial rate on these CDs is typically slightly higher than on a traditional CD since you’re taking on the risk of the bank calling the CD.
If you think a Certificate of Deposit could be right for you, look at different options; if the APY offered by your current bank seems low, you could be able to find a better rate online.
One last thing: be sure that you really understand the terms of your CD. Asking questions and doing research will help ensure you’re making the right choice.