A CD or certificate of deposit is a type of investment instrument that you purchase from a bank or credit union. When you deposit your money in CD, you promise to leave it there for a certain period of time.
In exchange, the bank pays a higher interest rate than you’d get with a regular savings account. On this page we’ll guide you through the basics of certificates of deposit, and will explain how they work and how you can invest in them correctly.
CD Rates 101
What influences CD rates?
CD rates are higher than regular savings rates, but less than mutual funds. Two things generally influence CD rates. First is the CD term. This is the amount of time you agree to leave your money in the CD. Generally speaking, the longer the term, the higher your CD rate will be. CD terms can be as short as 3 months or as long as 10 years.
Market interest rates also influence CD rates. The Federal funds rate is the rate at which banks loan money to each other. When the Federal funds rate goes up, CD rates will soon follow. And when the Federal funds rate goes down, CD rates also drop.
What is compounding interest?
When you earn interest on a CD, that interest is added the principle and you continue to earn interest on both amounts. For example, if you deposit $1,000 at 5% interest rate, you would earn $25 after six months. Then, your $1,025 would continue to earn interest at 5%. At the end of another six months (total of 1 year), you would have $1,050.63.
CD Rate vs. CD APY
When you see CD rates advertised, you might notice there are two different rates – an interest rate and an APY. Both of these are instrumental in figuring out how much the CD pays.
The interest rate on a CD is the annual rate you’d earn on the CD. For example, a 5% interest rate on a $1,000 CD would earn you $50.
Not all CDs pay interest on an annual basis and that’s where APY becomes important. APY stands for annual percentage yield. That’s the real rate at which you earn interest.
In the compounding interest above, you’ll notice when interest is compounded twice a year, or semi-annually, you really earn $50.63 in interest. The real interest rate – or APY – for that CD is 5.0625%. If you want to know how much interest you’ll really earn on your CD, use the APY rather than the interest rate.
The APY takes into account how often interest is applied to the deposit, in other words it helps calculate compounding interest. So, if interest is applied monthly, or bi-annually, the APY will be different than the interest rate. But if interest is applied annually, the APY and the interest rate will be the same.
Fixed vs. Variable Rate CDs
Most CDs have a fixed rate – an interest rate that stays the same throughout the term of the CD. If CD rates rise before your CD matures, you won’t get the benefits of those higher rates.
Variable CD rates do change during the term, but banks have different conditions on when the rate can increase and how much it can increase. Variable CD rates can also drop if market interest rates fall.
Investing in a CD
Where can I purchase a CD?
You can buy a CD through most banks and credit unions. There are also brokers who sell CDs with slightly higher CD rates, but you have to do more due diligence when you purchase a CD through a broker versus a bank or credit union.
What is the minimum deposit for a CD?
There are banks that don’t have a minimum CD deposit, but they are rare. Minimum CD deposits of $1,000 are more common.
What is maturity?
A CD is said to be mature when the term ends. When the CD reaches maturity, you’ll have short period of time to withdraw the money or it will be reinvested for another term. If you don’t do anything, most banks will automatically renew your CD.
Are there penalties for withdrawing before maturity?
Most banks charge an early withdrawal fee if you cash in your CD before it matures. Early withdrawal fees vary, but you can count on missing out on some or all of the interest you’ve earned and sometimes even part of the principle deposit.