What is Certificate of Deposit (CD)? - 2023 - Robinhood (2024)

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A CD is like a bank vault…

You put your money in the vault and give someone else the key. They promise to come back on a specific day with the key, and some additional cash. If you can wait, you’ll receive your money back, plus the contractual interest. If you summon them to open the vault early, they’ll charge you an early withdrawal penalty for making them show up before the agreed-upon date.

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When you open a CD, you have to commit to keeping your money in the CD for a set amount of time—the CD’s term. During the life of a CD, you generally cannot make any additional deposits or withdrawals. If you must make a withdrawal from the CD before its term ends, you will likely pay a penalty. Usually, the penalty is calculated based on the amount of your daily interest. Larger CDs tend to charge higher fees for early withdrawals.

For example, suppose that a bank was offering a 12-month CD with a return of 0.55%. Its early withdrawal penalty was equal to two months of interest. If you initially invested $10,000, you would have earned $55.00 in interest during the 12-month period. However, if you withdrew funds after nine months, you would have only earned $41.25 in interest. Unfortunately, the penalty would further reduce your earnings to $32.08 after the last 60 days of interest are deducted.

In exchange for committing to keep your money in the account for a set period, CDs usually have higher interest rates than other deposit accounts. When your CD’s term ends, the principal, plus all of the interest that you earned, can be withdrawn. At this time, you can also opt to add more money to the CD. If you take no action, most banks will roll your balance into a new CD with the same term as the previous one. If this happens, you can’t make a withdrawal without waiting until the new CD’s term ends. Once again, if you must make an early withdrawal, the bank will charge a fee. To give you a fair chance to make changes, most banks will notify you shortly before your CD matures.

One benefit of a CD as compared to securities like bonds or stocks is that the Federal Deposit Insurance Corp. (FDIC) offers insurance for CDs. If the bank holding your CD fails, the FDIC will reimburse you for up to $250,000 in losses. In contrast, equities or bonds lack similar insurance if they decline in value.

CDs also typically offer higher interest rates than traditional savings accounts. If you know that you won’t need to make a withdrawal for a certain period, a CD can potentially help you earn more interest.

The main risk of opening a CD is interest rate risk. The interest rate that the CD earns is set when you open the CD. If interest rates rise during the life of the CD, your investment will continue to receive the lower, original rate. Conversely, if rates drop, the CD will continue to earn the higher rate, making this both a risk and a potential benefit.

The best CD term for you varies with your financial situation and personal goals. One strategy is to time your CD to mature as close as possible to the date that you’ll need access to the cash.

For example, if you know that you want to buy a house in four years, you should consider opening a three-year CD. This will ensure that you have your money available to you when you start shopping for a house.

Interest rate risk is a concern that should be considered if you’re planning to open a long-term CD. You might want to open a shorter-term CD and deposit the proceeds into another CD instead of opening one long-term CD. This can help you reduce interest rate risk.

A CD ladder is a strategy that lets you put your savings into multiple CDs in order to manage your overall interest income while increasing the availability to make a withdrawal without paying any early withdrawal fees.

For example, if you have a savings account with $12,000, you can divide it into $1,000 portions. Then, open 12 CDs, one with a term of one month, another with a term of two months, a third with a term of three months, and so on.

Every month, one CD will mature, and you have the option to withdraw $1,000. If you don’t need to make a withdrawal, you can roll the balance into a new, one-year CD. Eventually, you will have twelve one-year CDs, with one maturing each month.

This strategy lets you increase your overall interest earnings while mitigating some of the inflexibility of using CDs.

The interest that you earn from money deposited to CDs is taxed the same way that interest earned from bank accounts is taxed. At year’s end, banks send a form 1099-INT to their customers with information about the interest they’ve earned.

The interest you earn in a CD is generally taxable in the year you earn it, while early withdrawal penalties are tax-deductible. The tax consequences are a bit different if you hold the CD in your tax-deferred retirement account, where you’ll pay taxes when you take distributions during retirement.

Savings accounts are designed to provide interest while maintaining flexibility. You can make deposits and withdrawals with few limits.

CDs tend to provide more interest than savings accounts, but you sacrifice flexibility.

Bank money market accounts combine features of checking and savings accounts. These accounts typically offer higher interest rates and more flexibility, such as the option to make debit card purchases or write checks. However, money market accounts have more restrictions than checking accounts, i.e., a limit on the number of monthly transactions. Banks also tend to charge higher fees on these accounts in exchange for their flexibility.

Some banks offer specialty CDs, such as bump-up CDs, jumbo CDs, and no-penalty CDs. These CDs alter the usual rules for CDs.

For example, bump-up CDs give you the chance to increase your interest rate a set number of times during the CD’s life. This only happens if market rates have increased. The feature can reduce the interest rate risk of a bump-up CD, but usually comes at the cost of a lower initial rate.

No-penalty CDs don’t charge early-withdrawal fees, but tend to have lower interest rates than traditional rates.

Jumbo CDs have high minimum balance requirements. Often, the requirement is $100,000 or more. In exchange for making such a large deposit, jumbo CDs tend to pay more interest than traditional CDs.

Calculating how much interest you will earn during the term of your CD is not complicated. In fact, you can calculate the total interest that you’ll earn using the standard compound interest formula. Here is the formula:

Ending balance = P * (1 + r/n)nt

P = principal

r = interest rate as a decimal

n = number of times interest compounds per unit of time

t = number of units of time

If you deposit $10,000 to a five-year CD with a 2% interest rate that compounds interest monthly, you’ll earn:

$10,000 * (1 + .02/12)12*5 = $11,050.79

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