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An Introduction to Certificates of Deposit (CDs)

If you keep a significant amount of money in a savings account, chances are that keeping risk to a minimum is important for you. While savings accounts certainly are safe, they pay just about the lowest returns you can get in the investing world. Certificates of deposit (CDs) offer a reasonable alternative; they pay more than a savings account, but provide the same level of certainty that your balance will only increase, rather than suffer a market-based decline. Below, we’ll take a basic look at CDs, how they work and how you can buy them.

What Is a Certificate of Deposit?

The definition of a certificate of deposit is a low-risk investment, sold by banks, credit unions and thrift institutions. That means the returns are pretty low, too. However, unlike with savings accounts, from which money can be withdrawn at any time, the bank expects to keep a CD for a specified time period (until maturity). This gives the bank some assurance that it’ll be able to use your money for other purposes (such as lending it to other customers or investing it), allowing it to pay a slightly higher rate of return. For investors, CDs are also one of the safest investments around. The interest rate is determined when you purchase the CD, and you’re guaranteed to get back what you put in—plus interest—as long as you leave the CD alone until it matures. Even if your bank goes belly up, the CD will be insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000. Find the most up-to-date CD rates with our Best CD Rates Tool.

Getting a CD is easy. Just tell your financial institution that you’d like to buy one. You’ll probably have to fill out a form or two, and then the money will be transferred to a CD in your name. Then it’s up to you to wait until it matures to collect your interest. Generally, larger deposits and longer time periods will result in a higher return. Smaller institutions also tend to offer higher rates, although keep in mind that some of them may not be insured by the FDIC. Find out how to save money in your everyday finances with 7 Sure-Fire Money-Saving Banking Moves.

Types of CDs

There are a few basic types of CDs you should know about before you get in on this investment.

  • Traditional CD: With this type of CD, investors receive a fixed interest rate over a specific period of time. At the end of this period, the CD is said to be mature, at which time the investor can withdraw the money. Withdrawing the money before the CD matures, however, will result in a substantial penalty fee.
  • Bump-Up CD: This type of account allows you to “bump-up” your interest rate to a higher rate if rates rise during your investment period. Generally, investors only get to bump once during the investment’s term [see also Best Financial Advice for Young Adults].
  • Liquid CD: A liquid CD allows investors to withdraw from their CDs without incurring the hefty penalty charged by most CDs in case of early withdrawal. This benefit means the interest rate on this type of CD is a little lower than others, but it still beats a savings account.
  • Zero-Coupon CD: In fixed-income speak, a “coupon” refers to the payout on a fixed term investment, like a CD. A zero-coupon CD, then, is a CD that does not pay out the interest at the end of the term; instead, it reinvests those payments, allowing investors to earn compound interest.
  • Callable CD:A callable CD is one that can be recalled by the issuer, at which time your deposit and any interest owed to you will be returned. Banks sometimes reserve the right to do this with CDs in case interest rates fall significantly during the period in which they’re held. The interest rates on these CDs may be slightly higher to account for the possible risk and inconvenience for the investor.

A Look at CD Strategy: CD Ladders

A common CD strategy is often to just shop around for the CD with the highest possible rate. That is not a bad idea, but you can do a lot more if you consider your investing goals and put some thought into it. There are a few types of CD strategies, but the simplest and most common is the CD ladder [see also Considerations When Choosing A Retirement Destination].

The idea here is to hedge the interest game by taking a lump sum and dividing it over a five-year period. It can work with three or four years as well, but the standard way is to do it for five years. So, let’s say you have $10,000 to invest. If you want to build a CD ladder, you would take the total and divide it into five increments and invest:

When the one-year CD expires, you take that money and invest it into a five-year CD, then continue this process along the ladder as CDs mature. So, when your initial two-year CD expires, you again buy a five-year CD, and so on. In a rising interest rate environment, this is a nice way to allocate some of your capital. However, if interest rates are unlikely to rise, this strategy may not be a good fit as CD rates will likely remain flat. If interest rates are declining, it’ll likely make more sense to lock in a CD for a longer term at the existing (higher) rate – or just seek a higher paying investment altogether.

Should You Cash Out?

By the same token, it can pay to cash out of a CD early, despite early withdrawal fees. If you have money tied up in a long-term, low-yield CD, it’s important to keep an eye on interest rates. If they begin to rise, it might be time to look into whether cashing out of your CD (and getting into a higher-yield one) is worth the early withdraw penalty. After all, being locked in at a 3% rate when rates rise to, say, 5%, is essentially a missed opportunity. Contact your bank to find out exactly what your penalty is on your CD, then compare it against the additional interest you’d earn at a higher rate to determine whether to make the switch.

When your CD matures, you usually have a window of time to decide what to do next, after which time your bank may automatically re-invest the funds into a new CD. CDs can be a good choice for very risk-averse investors. Just make sure you understand what you’re buying and how it compares to other investments.

The Bottom Line

CDs can act as a great alternative to low-yielding savings accounts as they can help you grow your money with relatively little risk. Be sure to take a look under the hood of a CD investment to ensure that you fully understand where you are putting your money.

Be sure to visit our complete recommended list of the Best Dividend Stocks, as well as a detailed explanation of our ratings system here.