What is a Certificate of Deposit Account and How Does it Work? What is a Certificate of Deposit Account and How Does it Work?
A Certificate of Deposit, or CD account is an interest-bearing account opened for a specific period of time that earns a fixed income on the amount initially deposited. CDs generally have a higher interest rate than traditional savings accounts and you can't withdraw any funds from the account before the maturity date without incurring a penalty fee or loss of interest.
Quick Links
- How Do CDs Work?
- How Does a Certificate of Deposit Differ From Savings Accounts and Money Market Accounts?
- What are the Advantages of a CD Account?
- What are the Disadvantages of a CD Account?
- How to Choose a CD Term
- How to Open a CD
- What Happens to a CD at Maturity?
- What if I Need to Withdraw From a CD Early?
Below we'll explore how CDs work, the differences between CDs and traditional savings accounts, the advantages and disadvantages of CDs, what CD term makes the most sense for you, and more!
Key Takeaways:
- A Certificate of Deposit is an interest-bearing account opened for a specific period of time that earns a fixed income on the amount initially deposited.
- CDs generally offer higher interest rates than traditional savings accounts.
- With a CD you make one initial deposit that you can’t withdraw until the account reaches its maturity date.
- If you do withdraw your money from a CD early you’ll most likely be assessed an early-withdrawal penalty by your financial institution.
How Do CDs Work?
When you open a CD, you'll agree to a fixed term for the account (usually anywhere from a few months to five years) which will in part determine the rate you receive on the account. With a fixed rate, unlike a savings account, your rate will be locked in for the entire account term -- it won't increase or decrease. There are positives and negatives associated with fixed interest rates that we'll dig into further below. The other important thing to know about CDs is that you are required leave your deposited funds untouched for a set length of time or you'll face penalty fees.
Banks and credit unions will explain all of the options available to you (account term, interest rate, any fees associated with early withdrawal) when you open your account. Other than that, CDs function similarly to other deposit accounts -- you'll receive monthly or quarterly statements and compounded interest payments deposited directly to your account balance.
How Does a Certificate of Deposit Differ From Savings Accounts and Money Market Accounts?
First off, let's cover how CD accounts are similar to standard savings and Money Market accounts. All three can be used to maintain and grow your money to help you achieve various savings goals. All three accounts are ideal if you don't need regular access to your money (unlike a Checking Account), although each offers differing levels of access to your funds.
With a traditional savings or Money Market account you can make additional deposits, and most savings accounts will allow you to withdraw or transfer funds from the account as needed. Money Market accounts are generally more restrictive in terms of the number of withdrawals you can make with a set monthly limit (for instance, you may be limited to six withdrawals per month from a Money Market account).
CDs limit both the amount of deposits and withdrawals you can make once your account is opened. You make an initial deposit when you open your account that will stay in the account until it reaches its maturity date. As mentioned above, early withdrawal of funds will likely result in penalty fees. CDs have less liquidity than standard savings or Money Markets but generally offer higher interest rates.
What are the Advantages of a CD Account?
Certificate of Deposits are a great way to maximize your savings if you have a larger future purchase you want to make (think a down payment on your next home or car). If you're looking to designate part of your savings for a future purchase and want it kept separate from your other funds, a CD is a fantastic option. CDs offer great returns without much risk -- you avoid the ups and downs of the stock market. Because of the fixed term and interest rate, you'll be able to calculate the guaranteed rate of return you'll receive on your account when you open it. Also, if interest rates decrease after you open your account, you'll be locked in at the higher rate you received at account opening. CDs also come in a variety of term options, so whether you'll need access to your funds in three months, a year, or not for five years, you'll be able to find an account that fits your needs. CDs also offer federal deposit insurance through the FDIC up to $250,000. And if you open a CD with Leader Bank you'll have access to additional Federal Deposit Insurance Corporation coverage for your deposits up to $100 million through the IntraFi Cash Service (ICS).
What are the Disadvantages of a CD Account?
If you don't want to commit to leaving your funds untouched for a set period of time, a CD may not be the best option for you. A CD is also more effective for growing an existing lump sum, so if you're just starting to grow your savings you may want to explore a high-yield savings account instead. While CDs offer guaranteed savings with low risk, they typically earn less than stocks and bonds over time. And while a fixed rate is great because you'll know exactly how much interest you'll earn over the term of the CD, if interest rates go up you'll be locked in at the lower rate that you opened your account at.
How to Choose a CD Term
As we mentioned above, CDs come in a variety of terms, both long- and short-term ranging from a month up to five years. There are a couple of important considerations when deciding which CD term is right for you.
The first is researching what is expected to happen to interest rates over the intended term of your CD. If, like in recent months, the Federal Reserve is in a pattern of raising rates you may want to consider a shorter-term CD instead of a five-year CD because you won't want to be locked into a lower rate for several years if rates are expected to go up. On the other hand, if the Fed is expected to lower interest rates a 5-year CD probably makes more sense so you can lock in a higher rate. Many banks and credit unions also offer options like a variable-rate CD or a bump-up CD which give you more wiggle room with the rate. A variable-rate CD offers an APY that moves with an index rate, so you'll only want to go with this option if rates are expected to go up (and stay up). A bump-up CD gives you the opportunity to increase your rate one time over the term. In turn, both variable-rate and bump-up CDs generally offer lower initial rates than traditional CDs.
You'll also want to consider your own financial needs including when you'll need access to your money. If there's a specific purpose or intended use for the money you are putting into a CD, you'll want to choose a rate that ensures you'll have access to those funds without incurring an early withdrawal penalty.
How to Open a CD
Opening a CD account is easy and can generally be done in a matter of minutes at your bank or credit union as well as through most online banks. The first step to opening a CD is to consider all of the factors mentioned above -- what your personal financial goals are, what the outlook is on rates, and what term makes the most sense for your goals. Once you settle on an account term, you can start the application and account opening process. Every bank or credit union will have a slightly different process for opening a CD account, but generally, you'll need to provide two forms of identification along with your address. Then you'll make the initial (and only) deposit into your account and you'll be good to go!
Wondering how much you'll need in terms of an initial deposit for a CD? This usually varies by financial institution, but many have minimum deposit requirements. For instance, Leader Bank requires a minimum deposit of $1,000 for both a short- and long-term CD.
What Happens to a CD at Maturity?
When your CD matures, your bank will reach out to you (usually a month or two in advance of the maturity date) to notify you of several options for what you can do with the funds. These usually include:
- Roll Them Into a New CD: If you don't have a pressing need for the money in the CD account you may choose to roll your deposit with the interest earned into a new CD.
- Transfer the Funds Into Another Account: If you have another account with the financial institution like a checking or savings account, you'll also likely have the option to transfer the funds into one of those accounts.
- Withdraw Your Funds: You'll also be able to withdraw your money either by transferring it into an account with another financial institution or having a check mailed to you.
Your financial institution will give you a deadline prior to your CD reaching maturity to choose which option you want to go with, and in most cases, if you fail to notify them ahead of this deadline they will simply roll your funds into another CD for you.
What if I Need to Withdraw From a CD Early?
Withdrawing money from your CD before it matures is never advisable, but if you absolutely need access to the money in the account you will be able to withdraw it. Your financial institutions will have terms that outline how they will handle an early withdrawal. There is such a thing as a no-penalty CD, but they often come with significantly lower rates and are thus a less lucrative investment. In most cases, your financial institution will assess you for an early-withdrawal penalty or fee on the interest you've gained before you get your money back. Any early-withdrawal penalties or fees will be outlined clearly when you open your account, so you'll know ahead of time how much an early withdrawal will cost you. Most commonly an early-withdrawal penalty will be charged as several months' interest -- the longer the term on the account the more months' interest you could be assessed. As a reminder, every financial institution will structure early-withdrawal fees differently so it's important to ask when setting up your account.
Looking to Get Started?
Leader Bank offers a range of Certificate of Deposit accounts with terms ranging from one month to five years. Opening an account can be done online and takes just a few minutes to get started!
