A decade ago, the abbreviation “CD” was most commonly used to refer to “compact discs.” Truth be told, many of us don’t even own a computer any more with a CD-slot, and as physical media has gone by the wayside, the use of CDs to play music has waned, as well.
These days, perhaps the most usual use of the term “CD” is in regards to a banking product called a “certificate of deposit.” While checking accounts and savings accounts are the most well-known banking products out there, a CD can be a powerful tool to earn a bit more interest on your money, albeit with some drawbacks.
What is a certificate of deposit?
At its core, a CD is a promise from you, the depositor, to place funds in a financial institution for a defined period of time. In exchange for this promise, you are paid a set amount of interest on the funds you deposited for the duration of the CD.
As opposed to a savings account, a CD comes with a promise by you, the depositor, to keep your funds with the banking institution for a pre-agreed period of time, generally 3, 6, 9, or 12 months. Some CDs may even last for multiple years.
How do CDs work?
Generally speaking, there are four component parts to a certificate of deposit:
- Principal deposited: This is the amount of money that you put into the CD. The principal is the dollar value off of which interest is calculated.
- Interest rate: This is the rate applied to the principal amount you deposit into the CD to determine the number of dollars in interest you will be paid.
- Term: This is the length of time that your money will be locked up in the CD (short of an early withdrawal and the ensuing penalties).
- Institution: This is the banking institution (or credit union) that you deposit your funds with. You want to ensure that the bank is FDIC-insured so that your money is protected.
What if I withdraw my money early?
CDs generally come with an early-withdrawal penalty. Because the banking institution at which you are depositing your money is promising you a fixed and generally higher interest rate that you would normally be able to get, they ask that you keep your money in place.
CDs are a tool that banks use to ensure that they have sufficient capital on their balance sheet to make the loans that drive their revenue. The promise you make to keep your funds in place enables the bank to have a high degree of certainty that they have a given amount of capital on their balance sheet.
If you break the promise of the CD and need to withdraw your funds early due to a financial emergency, for instance, you will be faced with paying an early-withdrawal penalty. These penalties generally are calculated as a number of days or months of interest.
For instance, if you put $1,000 into a 6-month CD earning 1% interest annually, you would expect to earn approximately $5 in interest at the end of the term. If you withdraw your money prior to the expiration of the 6-month term, it is likely that you will encounter an early-withdrawal penalty on the order of 3 months of the interest that you would have earned. There is frequently a minimum penalty amount of around $25, as well.
What does this mean? If you withdraw your $1,000 from a 6-month CD in month 2, you will be assessed a penalty of $2.50 if the bank only charges you 3 months of interest. However, if there is a $25 minimum penalty, then you’d see your take-home reduced by the full $25.
In other words, putting your money in a CD is a wise decision only if you have a high level of confidence that you will not need the money in short order.
Why do CDs matter?
Though we have been in a low interest rate environment for many years in the United States, CDs are a way to earn slightly more interest on your money. The major caveat right now is that even a high-interest-rate CD may only come with a rate at or slightly above 0.5% per year.
This means that–given the low interest rate environment we are in right now–a CD represents locking up your money for not much gain in terms of interest.
That being said, if you have cash that you don’t need now but will need at some point in the near future, a CD can be a great tool to maximize yield on your money, albeit at the expense of liquidity.