What is a CD?

And how do CDs work?

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?”

What is a certificate of deposit?

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 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 higher than those offered by a traditional savings account, often between 2% and 3%.

Banks value CDs because they can count on your money staying put for a certain period of time, allowing them to lend to others. But don’t worry, CD accounts are insured by the FDIC (more on that later).

How does a certificate of deposit work?

A CD investment is a way to put away money beyond what you’ve accumulated in your savings account, without taking on much more risk. While many people refer CDs as investments, they are not impacted by the stock market. Instead, think of it like buying a baseball card for your favorite player, knowing it 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 unique interest rate. So if you open a $10,000 1-year CD with a 2.25% interest rate, after a year, your account would be worth $10,225. Not a penny more or less.

Is a CD for you?

Like any investments, from the stock market to 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.

They’re also secure. While the return rate isn’t what you might find in stocks or mutual funds (assuming the market performs), there are typically no fees. Also, your CD is insured by the Federal Deposit Insurance Corporation up to allowable limits, meaning your money is safe from fraud or a bank closure.2

The main 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. Most banks charge you some of your accrued interest, and maybe even part of your original investment, if you decide to withdraw early.

The other disadvantage is that CD interest rates can sometimes struggle to keep up with inflation.2 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. This allows you to reap the benefits of a longer investment 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 access to your funds. Then, once you withdraw the money after a year or 2, you can decide whether to spend it or reinvest it, either in a new 5-year CD or something altogether different.

Many banks also offer some flexibility around when you receive interest payments, allowing customers to decide whether to have the interest disbursed monthly or annually.

What is an IRA CD?

Once you’ve answered your initial question— “Are CDs a good investment?”—you may start wondering whether CDs can be used for retirement. The short answer: yes.

An IRA CD is a good option for people closer to retirement, or anyone looking for the safest and most predictable retirement savings option. More aggressive IRA investments, like stocks and bonds, obviously carry the risk of losses. But not IRA CDs, where the rates are fixed and your money is FDIC insured, up to the allowable limits.

An IRA CD works just like a bank CD, but with the added tax benefits of an IRA. Everything else—the fixed term, the fixed rate and the early withdrawal penalties—is identical. And what is a Roth IRA CD? The same thing, basically, only with the tax benefits of a Roth IRA rather than a traditional IRA.

And that’s pretty much it—the lowdown on CDs (and not the kind that play the Spin Doctors). Whether you invest now or later, or decide they’re not for you, you should have enough information to decide if you want to make CDs a part of your financial life.

As for those compact discs? It’s probably time to let them go.

This site is for educational purposes. The material provided on this site is not intended to provide legal, investment, or financial advice or to indicate the availability or suitability of any Capital One product or service to your unique circumstances. For specific advice about your unique circumstances, you may wish to consult a qualified professional.

You May Also Like