When you put money into a bank certificate of deposit (CD), you expect to get it back at a specific time, plus the interest it has earned. In return for that security, you agree to leave your money on deposit for a specific period, typically ranging from six months to five years. The minimum deposit is often $500, but there’s rarely a ceiling, or upper limit. In investment terms, the money you put in is known as your principal. The length of the CD is its term, and the time it matures, or ends, is its date of maturity.
One of the first things you look for in a CD is the interest rate it pays and the annual percentage yield (APY), since they determine what you earn. Generally, with a longer term, you earn a somewhat higher rate, to make tying up your money more attractive. But the difference may not be large enough to justify the choice. Rates can vary significantly from year to year, as what a bank pays on its CDs and other deposits reflects the level of interest rates in the economy as a whole.
You can buy CDs through almost any bank or credit union, and can often handle the entire transaction electronically. Many people use a local bank for convenience. But if the rates offered at a distant or online bank are substantially higher, you may decide it’s a smarter choice, especially for large deposits. You can get a sense of current rates for CDs of various denominations in the financial pages of many newspapers and on financial websites.
WHAT HAPPENS AT MATURITY
When a CD matures, you decide what you want to do with the principal, but you may have to tell the bank in writing or by electronic communication what you’ve decided within the time limit it imposes. If you wait too long or never give instructions, the bank typically rolls over, or reinvests, your money in another CD for the same term at the current rate.
You might ask for a rollover in any case. But if you need the money, if the new rate will be lower than the interest you’ve been earning, or if you could earn more on a different investment, you might decide to cash in the CD. In that case, you can ask the bank to sweep, or move, the money into another of your accounts, transfer it electronically to another bank, or send you a check. There may be a fee for the transfer.
BUYING FROM A BROKER
You can also buy a CD through a stockbroker. Brokerage firms that buy and sell stocks and other investments buy large-denomination bank CDs, break them into smaller units, and sell them to individual investors. Because you own only part of a CD, you’re not committed to holding it to maturity and can typically sell without penalty at any time. However, unless there are buyers willing to purchase the CD at the rate it pays, you may have to sell for less than the principal you invested.
You may get a better interest rate with a broker CD, too, if the large underlying CD pays more. The trade-off for the earnings often means paying a commission, or sales charge, to the broker who sells you the CD, something you don’t pay for a bank CD. You’ll also want to be sure that you’ll be eligible for FDIC insurance with the CD.
CDs TO AVOID
Be very cautious about buying CDs with very long terms — ten years or more. They are often illiquid, which means you can’t sell them if you need the money.
COMPOUNDING IS KEY
What you actually earn on your CD, in dollars and cents, is the yield – specifically the annual percentage yield (APY). The yield depends on whether the interest is simple or compound, and how often it’s compounded.
Simple interest may be paid only once a year, on the amount of your purchase, while compound interest can be paid on a variety of schedules, from daily to semi-annually, on the growing balance in your account. Here’s an example of how interest is compounded when it’s paid quarterly.
If you have regular expenses, like tuition payments, or anticipate having to cover a large cost at a specific time, you can time your CDs to come due when you need the money. Banks and credit unions may be flexible, too, if you ask for a special term. For example, if you are planning to buy a house in seven months, you may be able to get a customized seven-month CD at a slightly better rate than a regular six-month variety.
- The yield is higher than on other bank accounts
- Knowing what you have and when you can take it out lets you plan for future cash needs
- You can choose a term that’s suited to your financial goals
- You pay no sales or management charges for a bank or credit union CD
- Changing economic conditions do not reduce what you earn on fixed-rate CDs
- Your bank CD is insured by the FDIC and credit union CDs are also insured
- Your money is usually locked in at a specific rate, even if interest rates go up
- You will probably lose some or all of the interest that has accumulated if you take your money out early
- You may earn more with other investment options
- The new interest rate may be lower when you reinvest, or roll over, your CD
- If your bank is taken over by another bank, your CD term or rate may change