How a Certificate of Deposit Works
Understand the mechanics of a Certificate of Deposit (CD), a reliable way to grow your savings over time.
A Certificate of Deposit (CD) is a type of savings account offered by financial institutions, including banks and credit unions. It allows individuals to deposit a specific sum of money for a predetermined period, earning a fixed interest rate.
Fundamental Characteristics
A Certificate of Deposit operates with a fixed term. Common terms range from a few months, such as three or six months, to several years, often up to five years, though some can extend to ten years or more.
CDs also feature a fixed interest rate, which is established at the time the account is opened and remains constant throughout the entire term. This rate does not fluctuate with market changes. Interest on CDs is typically calculated and compounded daily or monthly, meaning that earned interest is added to the principal, allowing it to earn interest itself.
The Annual Percentage Yield (APY) reflects the total amount of interest earned over a year, considering the effect of compounding, and is the most accurate measure for comparing different CD offerings. At the end of the chosen term, the CD reaches its maturity date, at which point the investor can access their original deposit, known as the principal, along with all the accrued interest, without incurring any penalties.
Key Operational Aspects
Withdrawing funds from a CD before its maturity date typically results in an early withdrawal penalty. These penalties are usually calculated as a forfeiture of a portion of the interest that would have been earned. If the accrued interest is insufficient to cover the penalty, a portion of the original principal may also be reduced.
The safety of funds in a CD is a primary benefit due to federal deposit insurance. Certificates of Deposit offered by banks are insured by the Federal Deposit Insurance Corporation (FDIC), while those from credit unions are insured by the National Credit Union Administration (NCUA). Both agencies provide coverage up to $250,000 per depositor, per institution, per ownership category, safeguarding the principal and accrued interest in the event of a financial institution’s failure.
Most CDs require a minimum initial deposit to open the account, which can vary significantly by institution and the specific CD product. While some institutions may offer CDs with no minimum deposit, common requirements often range from $500 to $2,500. Certain specialized CDs, such as jumbo CDs, typically require a much larger minimum deposit, often $100,000 or more.
Opening and Managing a CD
Opening a Certificate of Deposit involves a few preparatory steps and a clear procedural path. Individuals typically need to provide a government-issued identification, such as a driver’s license or passport, along with their Social Security Number or other tax identification. Details of the funding source for the initial deposit are also required. Before initiating the process, it is important to determine the desired term length and the amount to be deposited, aligning these choices with personal financial objectives.
Once the necessary information is gathered, the CD can be opened through various channels. Many financial institutions allow customers to open CDs online, providing a convenient and often quick application process. Alternatively, an individual can visit a bank branch in person or complete the process over the phone with a banking representative. After the account is successfully opened, the initial deposit is made, and the CD begins to accrue interest according to its fixed rate.
When a CD reaches its maturity date, the investor has several options for managing their funds. Most CDs include a grace period following maturity, typically ranging from 7 to 14 days, during which the funds can be withdrawn without penalty. If no action is taken during this period, the CD often automatically renews, or “rolls over,” into a new CD for the same term length, but at the prevailing interest rate offered by the institution at that time. Alternatively, the investor can choose to withdraw the entire principal and accrued interest, or opt for a partial withdrawal and reinvest the remaining balance into a new CD.