What is a CD?
And how do CDs work?
April 6, 2022 5 min read
CDs have been a staple of modern investing since the 1960s, and have existed in some form for centuries. Yet many people still have basic questions about them, like, “What does CD stand for?” “What is a bank CD?” and, “How do bank CDs work?”
For kids of the 1990s, CD means compact disc, specifically that one Spin Doctors album you totally bought the day it came out. But in banking terms, CD means certificate of deposit.
What is a certificate of deposit? The definition of certificate of deposit is an account that allows you to save money typically at a fixed interest rate for a fixed amount of time—say, 6 months, 1 year or 5 years.1 In exchange for leaving your money in the account, banks offer an interest rate that’s usually higher than those offered by a traditional savings account.2
How does a certificate of deposit work?
A CD is a way to put away money beyond what you’ve accumulated in your savings account, without taking on much more market risk.1 Think of it like buying a baseball card for your favorite player, knowing its value will go up when he retires in a year or two. Only in this case, you know exactly when he’ll retire, and exactly how much the card will be worth when he does.
If you’re wondering how to invest in CDs: You deposit a specific amount of money—say $5,000 or $10,000—into an account and agree to keep it there for a set amount of time in exchange for a set interest rate. So if you open a $10,000, 1-year CD with a 2.25% annual percentage yield, after a year, your account would be worth $10,225—assuming you keep interest payments in the account. Not a penny more or less.
Is a CD for you?
It depends—just like that baseball card collection, there are pros and cons of CDs. Weighing those upsides and downsides will help determine whether they’re right for you and your money.
The big upside of CDs is predictability. Because of the fixed rate and specific term, you’ll know exactly how much money you’ll have when you reach the end of your investment. Plus, they’re typically insured by the Federal Deposit Insurance Corporation (FDIC) up to allowable limits, meaning your money is safe from a bank failure at FDIC-insured institutions.3
One drawback of CDs is the lack of flexibility. Unlike a savings account, you can’t withdraw the money whenever you want—at least not without paying a penalty in many cases. Most banks charge you some of your accrued interest, and maybe even part of your original investment, if you decide to withdraw early.4
Another disadvantage is that CD interest rates can sometimes struggle to keep up with inflation.1 When inflation rises, the value of your dollar goes down. So if you invest $1,000 in a 1-year CD with a 1.5% interest rate, and inflation rises 1.9% in that same year, your money will be less valuable at the end of the year.
Are there ways to use CDs but stay flexible?
If you like the sound of CDs but want to keep your money accessible, you might consider building a CD ladder. That’s a plan in which you open multiple CD accounts for various amounts of time—6 months, 1 year, 2 years and so on.5 This allows you to reap the benefits of a longer savings timeline while still being able to access some of your money along the way.
So, say you’ve saved up enough in your savings account to cover yourself in a financial emergency. You have an additional $10,000 you want to put away, and you don’t think you’ll need the money for a while. You want to earn a little more than you do in that savings account, but you’re not ready to invest in the stock market. What do you do?
You could put all $10,000 in a 5-year CD. But then you couldn’t touch the money for 5 years without facing a penalty. That’s where the ladder comes into play. Instead, you could break the $10,000 into smaller chunks and buy 5 CDs—a 1-year, 2-year, 3-year, 4-year and 5-year—allowing you to earn a little more interest each year while keeping yearly access to some of your funds. Then, once you withdraw the money after a year or 2, you can decide whether to spend it or put it into another CD, either in a new 5-year CD or something altogether different.
Banks may offer some flexibility around when you receive interest payments, allowing customers to decide whether to have the interest disbursed monthly, annually or at the end of the term.1
What is an IRA CD?
A bank IRA CD can be a good option for people closer to retirement, or anyone looking for a safe and predictable retirement savings option.6 More aggressive IRA investments, like stocks and bonds, carry the risk of losses. But not bank IRA CDs, where the rates are fixed and your money is usually FDIC insured, up to the allowable limits.
An IRA CD works just like a bank CD, but with the added tax implications of an IRA. Everything else—the fixed term, the fixed rate and the early withdrawal penalties—are typically similar.6 And what is a Roth IRA CD? The same thing, basically, only with the tax implications of a Roth IRA rather than a traditional IRA.6
It’s up to you to decide whether a CD is right for you. But as for those compact discs? It’s probably time to let them go.