A certificate of deposit (CD) is a type of savings account that offers predictable growth and is often incorporated into retirement plans. With this investment strategy, you’ll benefit from federal protection and predictable interest.
In this article, we’ll explain what a CD is and how it works. We’ll also discuss important factors to help you decide if you should purchase one.
What does certificate of deposit mean?
By definition, a certificate of deposit is a contract between you and a financial institution, such as a bank or brokerage. You agree to keep a lump sum in a savings account for a set time period, often between 6 months and 2 years. In exchange, you earn interest as the funds mature. You usually pay a penalty if you withdraw money before the period ends.
CDs are typically considered safe, as the FDIC insures bank-issued CDs for up to $250,000. And if you purchase a CD through a credit union, the National Credit Union Administration (NCUA) provides the same level of coverage.
If you’re setting aside funds for a specific goal, such as making a down payment on a house or saving for retirement, you can choose a CD that aligns with your timeline. Your money will usually earn more interest than a standard savings or money market account.
How do CDs work? CD accounts explained
It’s important to understand the details before making a purchase, so here’s how CDs work:
- Initial deposit: You invest a lump sum into the CD account.
- Lock-in period: The bank holds your funds for the agreed term.
- Interest accrual: Your money earns interest at an agreed rate.
- Maturity: You receive your initial deposit back plus earned interest.
The interest on your CD account compounds, which means you earn returns on your initial deposit and on previously earned interest. Many institutions offer daily or monthly compounding, which can help your money grow faster.
Here’s a hypothetical certificate of deposit example: You invest $10,000 in a 12-month CD with a 4% APY. Your earnings could accumulate as follows:
- Total interest after 1 year: ~ $
- Final balance at maturity: ~ $10,400
When the CD’s term ends, you can withdraw your funds or roll them over into a new account. Either way, you’ll need to pay income taxes on your earnings (but not on the principal).
Top benefits of CDs
Here are a few benefits that set CDs apart:
- Regular earnings: CDs typically offer better returns than traditional savings accounts, which can help your money grow faster. And they tend to be more stable than high-yield savings accounts, where interest isn’t fixed and you can lose money when the Federal Reserve lowers rates.
- Predictable returns: With CDs, you lock in a fixed rate so you know how much you’ll earn by the end of the term. Let’s imagine that you deposit $10,000 into a 12-month CD at 4% APY. Monthly compounding interest means you’ll earn about $400 by the end of the year.
- Ladder options: Some people create CD ladders by opening multiple accounts with varying maturity dates. This offers regular access to funds and locks in high rates when they’re available. It also helps protect you from downturns when rates drop.
Key disadvantages of CDs
CDs also have some drawbacks you should consider, including:
- Limited access to funds: Once you deposit money into a CD, withdrawing it before the term ends can be difficult. Early withdrawals usually result in penalties, such as lost interest earnings and forfeited rate benefits.
- Inflation effects: If your CD’s interest rate is lower than the inflation rate, your money’s purchasing power declines over time.
- Locked rates: A fixed rate CD can tie your money to a low APY. While this may be a benefit when rates drop, it also prevents you from easily moving to an account with better returns.
3 common types of CDs
When deciding which type of CDs to purchase, consider these 3 popular options.
1. IRA CDs
IRAs help you save for retirement and come in 2 types: Traditional and Roth. Traditional IRA contributions are tax deductible, but you’ll need to pay income tax on future withdrawals. In contrast, you’ll fund Roth IRA accounts with after-tax dollars. While this won’t give you any benefits right away, you’ll have access to tax-free money during retirement.
No matter which type of IRA you choose, you need to actively invest your money. Otherwise, your IRA won’t earn interest, essentially turning it into a simple savings account.
To earn more, you can move some of your holdings into a CD. With this strategy, your CD benefits from tax breaks, and your IRA is protected by FDIC or NCUA insurance. This combination offers a reliable choice for individuals close to retirement who want predictable growth.
2. High-yield CDs
High-yield CDs offer better-than-average interest rates when compared to standard CDs. You’ll often find these savings products at online banks, which can offer more competitive interest rates due to lower operating costs. Other than these differences, high-yield accounts work the same way as traditional CDs.
3. No-penalty CDs
A no-penalty CD allows you to withdraw money early without losing interest, typically after the first week. This type of CD offers flexibility for unexpected needs, provides better rates than standard savings accounts, and protects your earnings even when interest rates drop.
One potential drawback of no-penalty CDs is the withdrawal limits, since many institutions don’t allow you to take out partial funds. Also, these CDs typically earn less than more traditional investment options.
Factors to consider when choosing a CD
To find a CD that meets your financial needs, look at what each offers in these key areas.
Interest rates
The CD interest rates an institution offers can vary from year to year, based on factors like Federal Reserve rates and market competition. Also, the rate you’re offered may depend on what you deposit and whether you have a preexisting relationship with the bank or credit union. It’s important to carefully consider timing and get quotes from multiple institutions.
Deposit amount
Some institutions don’t require a minimum deposit for CDs, while others set thresholds that can range widely. Before agreeing to a contract, make sure you have an adequate deposit that fits the bank’s criteria, and that you can safely avoid withdrawing money until the CD matures.
CD term
The term length you choose impacts both accessibility to your money and your potential earnings. Common term lengths include:
- Short-term CDs (3–12 months): Offer greater flexibility
- Mid-term CDs (2–3 years): Balance accessibility and returns
- Long-term CDs (4–5 years): Historically provide higher rates
Many banks offer higher APYs on 1-year CDs than 5-year CDs. You might consider setting up a CD ladder to benefit from different interest rates and maturity dates, so you can balance flexibility with earnings.
2 practical certificate of deposit examples
To understand how CDs work, let’s walk through a few hypothetical scenarios.
Example 1: Earning with a 5-year CD
Suppose you invest $5,000 in a 5-year CD with a 5% APY. Here's how your earnings might look year by year (rounding the totals):
- Year 0: Initial deposit: $5,000
- Year 1: Earn $250 in interest, balance grows to $5,250
- Year 2: Earn $265 in interest, balance grows to $5,515
- Year 3: Earn $275 in interest, balance grows to $5,790
- Year 4: Earn $290 in interest, balance grows to $6,080
- Year 5: Total earnings are $1,380, final balance is $6,380
Example 2: Early withdrawal
Now, let’s imagine you deposit $10,000 in a 5-year CD at a 5% APY. But you need to withdraw the money after 3 years, which leads to a penalty. Here’s how that could work (rounding the totals):
- Total interest earned: $1,575
- Early withdrawal penalty: $250 (equal to 6 months’ interest)
- Net earnings after the penalty: $1,325
Grow your savings with a Gainbridge SaveSM Annuity
Whether you’re saving for a big purchase or a comfortable retirement, a CD can be a relatively safe way to earn reliably. If your goals are more ambitious, though, you might also check out an alternative to a CD. For instance, a Gainbridge SaveSM Annuity offers fixed interest rates up to 6% and keeps your principle secure. You can choose terms between 3 and 10 years, and you don’t have to worry about commissions or hidden fees.
Find out if a Gainbridge SaveSM Annuity fits your earning goals.
This article is for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice. The Gainbridge Save® digital platform provides informational and educational resources intended only for self-directed purposes.
.jpg)
