What are CDs?

Piggy bank next to a sand hourglassI am not talking about compact music disk CDs, but instead certificates of deposit. So, what is a certificate of deposit and where might you find one? A certificate of deposit is like a savings account, but you get a higher interest rate because you are agreeing to leave the sum untouched for a specific period of time. CD products can be found at most financial institutions; typically banks and credit unions offer these products to their members. When reviewing CDs, you may notice that the lengths of time can be similar, but interest rates and early withdrawal penalties can differ because each bank typically sets their own.

Why would you open a CD? Certificates of deposit typically have higher interest rates than savings or money market accounts while maintaining less risk than investing in the stock market. CDs are unlike traditional investments because they can be insured by the NCUA and MSIC just like a savings or checking account. This makes them a great option for those who are risk averse and want their reserve savings to grow faster. For instance, CDs can be used to grow money saved for a down payment, new car, boat, or vacation that will be needed in the near or distant future.

Here is an example of why you might open a CD. If you intend to purchase a house in 7 months and have the down payment saved, you can put it in a 6-month CD to accrue a higher interest rate than a traditional savings or checking account. If you choose to invest in the stock market instead, there is a chance you might get a higher return but also a similar chance of taking a loss. Putting your money in a CD over the stock market in this situation can provide some assurance that you will be able to withdraw your principal amount after the maturity date with the interest. However, you will want to consider these certificates of deposit do have early withdrawal fees, so you would not want to open a CD for longer than you can be without immediate access to those funds.

For those who want to take advantage of long-term CDs rates without tying up their funds up for a long period of time can create what is called a CD ladder. Before you begin creating a CD ladder it is important to decide how often you want between CD maturities. If you want one CD to come up every 6 months vs once a year you will need to open more smaller CDs versus less larger ones.

For example, if you wanted to take advantage of the 2-year CD rate but want a CD to mature every 6 months and you only have $20,000 you can do that in the following way. You would need to open 4 CDs on the same day with $5,000 in each. Initially each CD will have a different length of time the first will be 6-months, the second will be 1-year, third will be 18-months, and fourth will be 2 years. You have now built what is considered a ladder that will allow one CD to expire every 6 months but not all have the higher interest rate you wanted. To get the higher interest rate once the first CD matures after 6-months you would renew it as a 2-year CD and so on and so forth as each one matures. After 2 years each of the four CDs will have the 2-year level interest rates with one maturing each 6 months for a constant flow of accessible funds giving you more flexibility with your accounts.

If you decide that a CD is the way to go, there are a few things to consider. To choose the right one for you, you will need to compare the annual percent yield (APY), dividend frequency, early withdrawal fees, and if there are any special features. First you will want to compare the annual percent yields (APY), an APY is the accounts interest rate minus any fees. APY allows you to compare products at two different financial institutions apples to apples and to show if there are any hidden fees and how they will impact your rate. The next thing to consider is early withdrawal fees. Even though you may not intend to withdraw the funds early, life is always full of surprises, so it is good to know in advance. This helps to ensure if you do need to take out your funds early for any reason you won’t be surprised with a super high fee.

Finally, you will need to consider any special features of the CD. Not all CDs are alike, and some can have added benefits, these include Bump-up CDs, Add-on CDs, No-penalty CDs, Jumbo CDs, and IRA CDs. A Bump-up CD allows for one or multiple opportunities to increase the interest rate over the life of the certificate. Typically, they allow for one “Bump-up” which increase the interest rate that can be locked in for the remainder of the CD, this is only if rates increase before the CD matures. Add-on CDs allow you to make additional deposits during the life of the CD. This allows you to add in additional funds to the CD principal over the CD time frame, the add-ons are normally regulated by minimum add-on deposits and the number of times the CD life. This allows you to increase the investment principal overtime to get the same interest rate on higher balances. No-penalty CDs typically have no early withdrawal fees, but to allow for no fees they normally come with a lower interest rate than regular CDs. Jumbo CDs are certificates for large minimum deposits, normally over $50,000 with special interest rates. Finally, there is the IRA CD that is a certificate for retirement funds that can be held in retirement accounts that grow tax fee.

After you decide on which CD works best for your needs it is important to know that dividend interest is included as a taxable income. Each year your financial institution will issue a tax form for interest earned of $10 or more in any deposit account. This is sent out every year you own the CD regardless of if the CD has matured or not. So, if you open a CD with a 5-year maturity time frame, you will get a tax form every year and not just at the end after it has matured, and you gain access to those funds. Some CDs also have automatic re-enrollment, so you will want to mark the dates each one matures down if you intend to move the funds to another account or make changes and don’t wish for it to be put into a new CD with the same length.

If you are considering opening a certificate of deposit you can check out our earning opportunities on our website or stop by a branch to talk with one of our financial professionals!