How do Certificates of Deposit Work?

Aug 28, 2019

  • Savings Accounts
  • Banking
  • Certificates of Deposit

If you’ve been putting money into a savings account that you rarely withdraw from, a certificate of deposit may be a better option.  Certificates of deposit lock up your money for a designated time, and in most cases, the interest rate is higher than what is offered on a savings account.

How CDs Work

Money that's deposited into a certificate of deposit is required to stay in the account for a designated length of time. When that designated time is over, you’ll have access to the interest earned and the sum of money originally deposited. The time that you keep the money in a certificate of deposit can vary from months to years depending on the offer you choose. The designated period of time is known as the “term.” Generally speaking the longer the term, the higher the interest rate earned. The maturity date is the specific month and day that the term is over.

If you have a CD that you want to close or withdraw the money from before the term is up, you'll pay an early-withdrawal penalty. This penalty will vary depending on the financial institution's policies. Typically, the penalty is based on the length of the CD and a predetermined number of months of interest.

Why Consider a CD

A CD may be a good option if you have a dormant account, have a savings account with little or no withdrawals, or another type of account that you're using for a long-term goal. An example of a long-term goal could be saving for a new car or a down payment on a home. Be sure to check the interest rate on your existing account, and then shop around for a CD that carries a higher yield.

Common CD terms are three, six, nine, twelve, twenty-four, and sixty months. Make sure you determine how long your money can be tied up before opening a CD. In the end, early-withdrawal penalties may not be worth the higher interest rate earned on a CD.

Another strategy, to keep money on hand, is to open multiple CD accounts with varying terms. For example, you might open six-month, nine-month, and one-year CD accounts, staggering the maturity dates. This way if you need money unexpectedly, you won’t be too far away from the end of one of the CDs maturity date. This strategy is called CD laddering.

Types of CDs 

There are also a variety of types of CDs offered through financial institutions. The traditional CD has a fixed interest rate for the entire term and requires an early-withdrawal penalty if you cash out before the time is up. However, there are more flexible CD options that you may also want to consider.

A liquid CD will allow you to take out your funds without paying an early-withdrawal penalty. Also known as a "No Penalty" CD, the flexibility of withdrawing does come with a tradeoff. Interest rates offered for a liquid CD are lower than traditional CDs, where you're locked into a designated period. Be sure to review the details before investing in a liquid CD. There could be limitations as to when you're able to pull the funds, or how much of it you can withdraw.

Step-Up CDs automatically schedule increases in the interest rate. You're not locked into the rate that you opened the CD at. The increases will vary, potentially occurring every few months or once a year if it's a longer-term CD.

Another type that's similar to a liquid CD, is the bump-up CD. It offers a similar benefit of not being locked into a lower interest rate from the time you originally opened the CD. The financial institution will switch to a higher interest rate with the existing account. This is assuming that a higher interest rate has been offered by the institution. Sometimes you'll have to proactively inform the financial institution that you want the new rate applied for them to change it.

An additional choice is Brokered CDs, which are sold through brokerage accounts. These CDs often offer better interest rates. Brokered CDs can be bought from different banks and kept in one place versus having to open accounts at various banks. Make sure that the banks you're considering are FDIC insured.

If you're ready to open a certificate of deposit, NASB offers high-interest rate CDs with low minimum opening requirements. Give us a call at 800-677-6272 to talk to one of our experts today. And for more information, check out our NASB Now video series, Understanding Certificates of Deposit.