Certificates of deposit have a long history of delivering steady, guaranteed returns. Now with rising interest rates and increased competition among banks and credit unions, CDs have become even more lucrative to depositors, with plenty paying APYs of upwards of 5% (see some of the highest CD rates you may get now here). But before you deposit your hard-earned money, experts say there are some things everyone should know first.
Everything from varying rates to term lengths to minimum deposits and fluctuating market conditions can play a role in determining whether investing in a CD is the most optimal use of someone’s money, says WalletHub analyst Jill Gonzalez. “You need to be familiar with the terms and decide on a CD that aligns with your financial needs,” Gonzalez says. For those who want guaranteed returns and can lock up their money for a time, a CD may be an excellent option; for those who need their savings more liquid, a high-yield savings account may be the way to go (see some of the highest savings account rates you may get now here).
Because this decision can be complex, savings pros say these are the 10 most critical factors everyone should consider before opening an account.
1. Types of certificates of deposit
Since they were first introduced by the First National City Bank of New York in 1961, CDs have expanded to more than just one simple form. So before you start to decide where to open your next account, it’s important to know what you’re looking for, Gonzalez says. Here are the 12 most common types of CDs:
- Traditional CD: The traditional certificate of deposit typically requires a minimum deposit and that account holders leave their money invested for a predetermined set of time. If you meet those rules, then you stand to earn a previously determined interest rate. The biggest risk here is if you pull out your money prior to the maturity date, you will often face a penalty that includes interest and/or principal.
- Bump-up CD: If rates go up while you’re invested, this version allows depositors to make a one-time increase. One downside here is the bump-up CD often comes with a lower starting rate than a traditional CD.
- Step-up CD: This version also locks in your money for the duration of the previously determined maturity date; pull your money early and you may get hit with an early withdrawal penalty. The key difference here is that the interest rate can theoretically increase along with rising interest rates — and you don’t have to request the increase like you would with a bump-up CD. Some downsides are that the rates are often not as competitive as traditional CDs, and the increased rate is often a blended APY with the current term and increased rate. So if you started with a 0.05% rate and it increases to 0.65%, you may only “step up” to a blended 0.35% rate, according to one example on Investopedia.
- Add-on CD: Unlike the traditional CD, the add-on CD allows depositors to make additional deposits throughout its term.
- No-penalty CD: Like the name suggests, investing in a no-penalty CDs means there is no early withdrawal penalty for taking out your money before the maturity date. These rates are often lower than the traditional CD, however many choose this option to have more liquidity.
- Zero-coupon CD: These CDs do not pay any interest at all, however investors have the opportunity to purchase at a steep discount and receive a guaranteed amount of increased principal at the end of the maturity period. Terms here are typically longer than a traditional CD and account holders often have to declare accruing interest on the CD each year and pay taxes rather than paying the taxes in full at the end of the term. This usually results in a larger tax bill.
- Callable CD: This type comes with a call feature, allowing the issuing bank to redeem the principal prior to the previously stated maturity date. Banks often make the decision to end a callable CD early when the interest rate agreed to at the time of purchase decreases. If a CD is called back, the bank would then return your principal plus the earned interest at that period. If you wanted to stay with that particular issuer, you would have to purchase a new CD at the current rate.
- Brokered CD: Rather than purchased directly through a bank or credit union, a brokered CD is purchased through a broker or brokerage firm, or through a sales representative at a bank. These CDs can also be traded like bonds so they are in effect a more liquid option than a traditional option.
- High-yield CD: These are offered by banks or credit unions actively engaging in competition with one another to offer the highest possible rate for a CD.
- Jumbo CD: If you have more than $100,000 to invest, then a jumbo CD might be what you’re looking for. These CDs often come with higher rates and also offer longer maturity periods. Read here for more.
- IRA CD: This type of CD is one of many ways an individual’s IRA assets can be invested. While IRA CDs can indeed earn a fixed interest rate, some financial institutions may even offer a variable rate on these products. Here’s how an IRA CD can help you with a tax hit.
- Foreign currency CD: If you’re interested in earning interest on a currency other than the U.S. dollar, then a foreign currency CD might be what you’re looking for. These can be purchased at a U.S. financial institution that offers foreign currency accounts or at a bank that offers international investments.
2. Annual percentage yield
Generating a return is key with any form of investment. And it’s no different with CDs. That’s why knowing how CDs earn interest is one of the most important things to understand. For the actual rate of return on your investment, CDs produce what’s known as an annual percentage yield, also known as APY.
APY factors in the effects of compound interest, which reinvests the interest earned and generates additional earnings over time. Over the length of the investment, then the interest grows and so too does the total balance. For example, let’s say you had $1,000 invested in a 5% APY CD. By the end of the 12-month term, you would have earned $50 of interest, with a total balance of $1050.
3. Fed funds rate
Banks and credit unions determine a CD’s APY based on several factors. One of the biggest is directly related to the decisions made by the Federal Reserve. That’s because the deposit rate for many savings products fluctuates based on the adjustments made to the national borrowing rate set by the central bank. While on one hand the rising Fed funds rate makes loans more expensive for banks and credit unions, any increase also incentivizes many banks and credit unions to raise cash and attract new customers to pay off their own debt and balance their books.
How does the central bank decide whether to raise or lower these rates? As of late, it has been focused on bringing down national inflation, which ballooned during the COVID-19 pandemic last June to a 41-year high or 9.1%. In order to lower consumer prices back down to the Fed’s target of 2% inflation, the central bank has steadily increased the borrowing rate from nearly zero one year ago. Because banks now have to pay interest on their own debt, their incentives to pay higher APY has also increased as a result. (See some of the highest CD rates you may get now here.)
Katie Catlender, chief customer officer at Cambridge Savings Bank, says these decisions have in turn made CDs more profitable to depositors. “People who have extra money to put towards savings are fortunate because interest rates are at record highs right now, and there is the opportunity to earn more on your dollar over time because of those high rates, Catlender says, adding that “earning the most on your dollar is so important as a savings strategy, and there are several options for earning interest on your money, and choosing between products like a savings and CDs is a personal choice based on an individual’s financial situation.”
To be sure, the average 12-month CD deposit rate has grown to 1.76% APY, as of Aug. 21, according to FDIC data. Just one year ago, the average 12-month CD delivered a rate of just 0.46% APY. For a look at how elevated competition has impacted some of the offers at the more niche, community banks and credit unions, here are some of the highest rates that can be earned right now.
4. CD terms
Another key consideration to make prior to opening a CD is determining how long you’ll have to remain invested to earn the promoted rate. When looking through a CD’s promotional page on a bank or credit union website, there is often a tab for rates and how those rates vary depending on the available terms.
Generally speaking, the longer the term, the better the rate. However promotional rates for a shorter term CD, say one ending in nine months for example, can offer the best rate in order to attract new customers.
Buying a CD, says Ed Williams, senior lead planner at Facet, ultimately means that you’re “parking that money to the bank account for a minimum period of time” adding that anyone interested in opening a CD should avoid spending “money that you might need to access on a regular basis”
That’s why considering your investing time horizon is so critical, says Brian Snerson, managing director at Essex Wealth Management of Summit Financial. “If a young couple is looking to buy a home in two to three years, they may be better served allocating extra money beyond emergency funds into CD’s rather than a savings account as they generally offer better interest rates,” Snerson says. “Longer term CD’s generally have more favorable rates. If you can afford to let the money sit for a while and earn a better yield, CD’s are generally a better option than savings accounts.”
After reaching the maturity date, account holders will have the option to extend the term or roll their earned interest into a new CD. More on that later.
5. Early withdrawal penalties
If you plan on pulling your principal deposit out before the end of the term, or maturity date, most CDs typically come with what are known as early withdrawal penalties. These fees often charge a certain percentage of earned interest. For example, Investopedia offers these hypothetical scenarios:
- CDs that have a maturity date of six months or more may charge the equivalent of three months’ interest for taking your money out prior to that six-month date.
- Longer-term CDs, however, may charge as much as 12-months interest or more.
Avoiding an early withdrawal penalty, though, is pretty simple: just stick with the CD until the end of the previously specified maturity date.
6. Deposit minimums
Like with many savings products, opening a CD may come with some restrictions in order to earn the rate found in its marketing material and promotional offers. One of the biggest ways banks and credit unions limit access to rates that are well above the national average, and one of the biggest ways they can raise cash, is by requiring new depositors bring a minimum amount of money to the bank to get started.
For example, so-called jumbo CDs require depositors to bring at least $100,000 to earn an often higher-than-average rate. Just be sure to read the fine print for any offer you’re interested in to ensure you have the cash needed to qualify.
When it comes to making a deposit, customers of these time-based deposits are also often only insured at banks for up to $250,000 in principal and accrued interest by the Federal Deposit Insurance Corporation, also known as the FDIC, regardless of how high their maximum allowable investment goes. The National Credit Union Administration, or NCUA, meanwhile insures up to the same amount but at credit unions. Be sure to read the details to ensure your money is safe.
Another key factor to consider with any interest earned on a CD is Uncle Sam. That’s because that cashflow is taxable as regular income. That is, however, unless you have opened a tax-advantaged account such as an IRA CD. Here’s how an IRA CD can help you with a tax hit.
In most other instances, though, taxes for CDs will often range from 10% to 37% depending on your taxable income and filing status. If you’ve earned any form of interest in excess of $10, most banks will often issue a Form 1099-INT to file your earned interest with the IRS. If they are not issued, you may have to request one.
After your CD reaches its maturity date, depositors may have a few options with their CD. For one, they may elect to renew their CD at the same interest rate at the end of the term if the bank or credit union offers this option.
Another possible choice is to roll the deposit into a new CD at the bank. If you go with this choice, the new CD would come with whatever its terms are at the time. Often this is the best choice if rates are higher at the time of your new term than when your first opened the original account.
The third option is to simply cash in your CD and withdraw your initial deposit and interest earned over the life of the investment.
10. CD laddering
Another strategy to consider before opening a CD is CD laddering, which can generate a steady stream of guaranteed returns for as long as you choose to remain invested. Rather than investing all of your money into one into one short- or long-term CD, a clever investing approach known as CD laddering calls for spreading a lump sum of cash across multiple CDs, allowing the investor to reap the rewards of the higher interest rates often associated with longer-term products, as well as the ability to access your funds on a more frequent basis.
How does it work? Let’s say you have $10,000 set aside to open a single CD. Instead of putting it all in one place, CD laddering would call for opening multiple CDs with less of your money in each. For example, you would alternatively invest $2,000 into five separate CDs —with one-, two-, three-, four- and five-year maturity dates. Then, when those CDs come to the ends of their respective terms, depositors would then reinvest their lump sum into another five year CD. After the fifth year, you would then have a portfolio of five-year CDs, each of which maturing every year. Read here for more on how this strategy works.