Do Certificates of Deposit Build Credit?
Understand if Certificates of Deposit contribute to your credit score. This article clarifies their role and offers effective credit-building methods.
A Certificate of Deposit (CD) is a savings account where money is deposited for a fixed period at a specific interest rate. These financial products are low-risk ways to save and earn a guaranteed return. Many individuals wonder if opening and managing a CD can contribute to building credit. This article explores Certificates of Deposit and their relationship to building credit.
Understanding Certificates of Deposit
A Certificate of Deposit is a savings instrument offered by banks and credit unions that holds a fixed amount for a set period, known as the term. Terms range from a few months to several years, commonly three months to five years. In exchange for keeping funds deposited for the entire term, the financial institution pays a fixed interest rate, often higher than standard savings accounts.
Funds are inaccessible until the maturity date without incurring a penalty. This early withdrawal penalty can significantly reduce the interest earned or even dip into the principal amount. CDs are federally insured by agencies like the Federal Deposit Insurance Corporation (FDIC) for banks, up to $250,000 per depositor per insured institution.
How Credit Scores Are Built
A credit score is a numerical representation of creditworthiness, used by lenders to assess lending risk. Common credit scoring models, such as FICO and VantageScore, analyze credit reports to generate scores. These reports contain a history of borrowing and repayment activities.
Several factors contribute to a credit score, with payment history being the most influential component, accounting for 35% of the score. Amounts owed, or credit utilization, is another significant factor, making up 30%. Length of credit history, new credit inquiries, and mix of credit types also play roles in the overall score.
The Role of CDs in Credit Building
Standard Certificates of Deposit do not directly contribute to building credit. As savings vehicles, financial institutions do not report CD opening, management, or maturity to credit bureaus. This means depositing money into a CD and letting it mature will not appear on a credit report or influence a credit score.
However, a CD can indirectly assist in credit building through a CD-secured loan. Some financial institutions offer these loans, where the CD serves as collateral for the borrowed amount. This structure reduces the risk for the lender, making it easier for individuals with limited or no credit history to qualify.
When a CD-secured loan is taken out, the loan payments are reported to credit bureaus. Making consistent, on-time payments on this loan can establish a positive payment history, which is a primary factor in credit score calculation. The CD continues to earn interest while it is used as collateral, and the borrower receives the loan funds. Upon successful repayment of the loan, the CD is released back to the borrower.
Other Effective Credit Building Strategies
Given that a CD does not directly build credit, individuals looking to establish or improve their credit can explore several other strategies. One common method is obtaining a secured credit card, which requires a cash deposit that acts as the credit limit. On-time payments on a secured card are reported to credit bureaus and can help build a positive credit history.
Another option is a credit builder loan, where a financial institution lends money that is held in a locked savings account or CD until the loan is fully repaid. The borrower makes regular payments, which are reported to credit bureaus, and receives the funds at the end of the loan term. Becoming an authorized user on a trusted individual’s credit card can be beneficial, as the authorized user’s credit report may reflect the primary cardholder’s good payment history.
Beyond specific credit products, consistently paying all bills on time, including utilities and rent if reported, is important for credit health. Maintaining a low credit utilization ratio, which is the amount of credit used compared to the total available credit, also positively impacts scores. Diversifying the types of credit managed responsibly, such as having both revolving credit (like credit cards) and installment loans (like auto loans), can further demonstrate creditworthiness.