What is a Certificate of Deposit (CD)?

Definition and Examples of Certificates of Deposit

How Certificates of Deposit Work

Types of Certificates of Deposit

Advantages and Disadvantages of Certificates of Deposit

Alternatives to Certificates of Deposit

Definition and Examples of Certificates of Deposit

A certificate of deposit (CD) is a savings tool that keeps a specified amount of money for a specified period and earns a fixed return. A CD is considered an account where you place your money and agree to leave it in the account for a set period known as the maturity period. In return, the institution pays you a higher interest rate than you would find in a typical savings account.

How Certificates of Deposit Work

Certificates of deposit work exactly like savings accounts, except you agree not to access the funds in the account until maturity. Once you commit the money, the bank places your funds in the account and pays interest on the account. If you need to withdraw your money before maturity, many banks may charge you an early withdrawal fee.

When the maturity period of the certificate of deposit ends, you can withdraw your funds without penalties by transferring them to a regular checking account. Alternatively, you can choose to reinvest them. Some banks even offer you the option to automatically reinvest them into a new certificate of deposit.

Note: You can open multiple certificates of deposit and use a laddering strategy to stagger maturity dates and achieve higher interest rates on some of your money.

Types of Certificates of Deposit

In addition to traditional CDs, you’ll find versions that feature attributes such as more liquidity and the flexibility to add funds or take advantage of interest rate changes. Some available options include no-penalty CDs, add-on CDs, bump-up CDs, and individual retirement account (IRA) CDs.

Advantages and Disadvantages of Certificates of Deposit

Advantages:

• Fixed returns
• Higher rates than other savings accounts
• A variety of options available
• Safety through deposit insurance

Disadvantages:

• Liquidity constraints
• Lower returns than riskier investments
• Early withdrawal penalties
• Inflation risk
• Income taxes on earnings

Alternatives to Certificates of Deposit

If the various types of certificates of deposit do not provide what you need, you may benefit from other options. Although you may not achieve a higher return, you have quicker access to your funds and the option to add to your investment at any time. Money market accounts, basic savings accounts, and high-yield savings accounts are some alternatives you might consider.

Money Market Account:

Although it is designed for savings, a money market account shares some similarities with a checking account. For example, some accounts allow you to write checks. Additionally, the interest rate earned can be similar to that of some certificates of deposit, but it may depend on your account balance.

High-Yield Savings Account:

While they may offer similar interest rates to a CD, high-yield savings accounts serve as a better-performing alternative to basic savings accounts. These accounts feature flexibility in deposits and withdrawals, offering high liquidity. However, they might require a minimum balance to earn interest or enjoy the highest yield. You can search for high-yield savings accounts online for more competitive rates and find options with no fees or minimum balance requirements.

Summary

A certificate of deposit begins by allocating a certain amount of money for an agreed-upon term. You can find certificates of deposit with various options concerning duration and interest rate structures, as well as selected types like no-penalty CDs, add-on CDs, bump-up CDs, and IRA CDs. You benefit from low-risk exposure with a CD, where returns are more predictable. Your account is generally insured at the federal level, and you can access funds in emergencies while incurring early withdrawal fees. CDs typically offer higher returns than traditional savings accounts but do not surpass investments like stocks and bonds. When the maturity period of a CD ends, you can decide to withdraw the balance or continue to reinvest.

Source:

https://www.thebalancemoney.com/what-is-a-certificate-of-deposit-cd-5223348