What is a CD?
A certificate of deposit (CD) is a financial product widely offered by banks and credit unions that generally pays a fixed interest rate for a predefined time period. They are one of the most common ways people save money and are heavily utilized by individuals and businesses across the U.S. In almost all cases, CDs are completely safe because they are insured by either the FDIC or NCUA.
Opening a CD is similar to opening a standard bank deposit account. What makes it different is what happens to the money afterward. With standard bank deposit accounts, money is free to be deposited and withdrawn as the account holder pleases. With a CD, the money is expected to be kept in the account for the entire duration of the CD. The account is basically locked. The penalty for withdrawing early is generally the loss of the principal or the loss of the interest on the CD. In return, the interest rates for CDs are usually higher than standard bank deposit accounts. Please note that the CD Calculator does not account for early withdrawals.
Before purchasing CDs, it is important to shop around, as rates vary widely between financial institutions. Usually, the longer the term of the CD, the higher the interest rate, though this is not always the case. There is no particular limit to the term length of a CD, but the most common terms are 6-month, 1-year, and 5-year CDs. A 5-year CD will normally yield a higher rate of return than a 6-month CD. It is possible to find CDs with term lengths of up to 10 years, though they are uncommon.
Laddering CDs
Buying one CD, waiting for it to mature, and either spending the cash or rolling it into a new CD is perfectly fine. However, a common strategy to maximize returns, while maintaining a degree of liquidity, is to build a "CD ladder." Laddering entails buying multiple CDs of varying term lengths. It can help an investor overcome the two major drawbacks of CDs: being locked into a fixed rate (which might be detrimental if interest rates rise over time) and the inability to access the funds (for an emergency or otherwise). It is generally advisable not to place emergency funds inside a CD, as early withdrawal of funds normally comes with a penalty.
Constructing a CD ladder involves dividing an initial investment amount into equal parts and purchasing CDs that mature at regular intervals. As each CD matures, the funds (initial investment plus the accumulated interest) are reinvested into another CD at the longest-term rate.
Example:
Suppose someone has $5,000 to invest in CDs and wants to build a five-year ladder. They would divide the $5,000 into five equal parts of $1,000 and invest each part in a different CD with varying maturity dates, such as a 1-year, 2-year, 3-year, 4-year, and 5-year CD.
When the 1-year CD matures, the investor has the option to withdraw the $1,000 plus the accumulated interest or reinvest it into a new 5-year CD. When the 2-year CD matures the following year, the investor will again have the option to withdraw the funds or reinvest them into another 5-year CD. This process continues for each maturing CD.
Assuming the investor reinvests the funds into a new 5-year CD each time, by the time the original 5-year CD matures, the investor will have a portfolio of five CDs, each with a 5-year term but maturing one year apart. This strategy allows the investor to benefit from the higher interest rates typically associated with longer-term CDs while still having access to a portion of their funds every year.
Taxing of CDs
It is important to remember that CD yields are normally taxed as interest income, not as capital gains. Generally, they are federally and state-taxed. In the U.S., financial institutions report CD interest earnings via Form 1099-INT. A way to sidestep this is to place CDs in tax-advantaged accounts such as IRAs or 401(k)s.
Compounding Frequency
Before purchasing a CD, it is important to find out the compounding frequency, which determines how often interest is calculated and added to the principal balance. Depending on the financial institution, the compounding frequency can be daily, monthly, semi-annually, or annually.
The more frequently interest is compounded, the higher the APY will be, resulting in a higher return on investment. Therefore, a CD that compounds interest daily will have a slightly higher APY than a CD with the same interest rate but compounds interest monthly. For most CDs, the APY is slightly higher than the nominal interest rate, unless the interest is compounded annually, in which case the two rates are equal.
It is worth noting that some CDs do not compound interest but instead pay out the interest to the account holder on a regular basis, such as monthly or annually. In this case, the APY will be equal to the nominal interest rate.
Alternatives to CDs
While CDs are a safe and reliable way to save and grow money, they may not be the best option for everyone. There are several alternatives to CDs that offer varying degrees of risk and return.
High-Yield Savings Accounts
High-yield savings accounts (HYSA) are similar to traditional savings accounts but offer significantly higher interest rates. Like CDs, HYSAs are insured by the FDIC or NCUA, making them a safe place to store money. Unlike CDs, however, HYSAs offer liquidity, allowing account holders to withdraw or deposit funds at any time without penalty. Because of this flexibility, HYSAs generally offer lower interest rates than CDs.
Money Market Accounts
Money market accounts (MMA) are another safe and liquid alternative to CDs. They are a hybrid between a savings and checking account, offering the interest-earning capabilities of a savings account and the check-writing and debit card privileges of a checking account. MMAs typically offer higher interest rates than traditional savings accounts but often require higher minimum balances. Like CDs and HYSAs, MMAs are insured by the FDIC or NCUA.
Treasury Securities
Treasury securities are debt instruments issued by the U.S. Department of the Treasury. They are considered one of the safest investments because they are backed by the full faith and credit of the U.S. government. There are three types of Treasury securities: Treasury bills (T-bills), Treasury notes (T-notes), and Treasury bonds (T-bonds), which have varying maturity lengths. Treasury securities offer competitive interest rates and are exempt from state and local taxes, making them an attractive alternative to CDs for investors in high-tax states.
Corporate Bonds
Corporate bonds are debt securities issued by corporations to raise capital. They typically offer higher interest rates than CDs and Treasury securities but come with a higher degree of risk, as the issuer could default on its payments. The risk and return of a corporate bond are closely tied to the creditworthiness of the issuing company. Corporate bonds can be purchased individually or through mutual funds and exchange-traded funds (ETFs).
Dividend-Paying Stocks
Dividend-paying stocks are shares of companies that distribute a portion of their earnings to shareholders on a regular basis. While stocks are generally riskier than CDs, they offer the potential for higher returns through both capital appreciation and dividend income. Dividend-paying stocks can be a good alternative for investors seeking higher yields and who are willing to tolerate the volatility of the stock market.