How a Certificate of Deposit Works in Banking

A Certificate of Deposit (CD) is a savings product offered by financial institutions, including banks and credit unions. CDs provide a secure, low-risk way for individuals to save money. They function distinctly from traditional savings accounts by locking in funds for a specific duration in exchange for a fixed interest rate.

Understanding Certificates of Deposit

A Certificate of Deposit is a time deposit account where funds are held for a fixed term, earning a predetermined interest rate. Key components include the principal (initial amount deposited), a fixed interest rate that remains constant, and a fixed term or maturity date, specifying how long the money must remain in the account. This agreement allows the financial institution to offer a higher interest rate compared to a standard savings account.

Interest on a CD is calculated and accrued daily, though it may be paid out monthly, quarterly, semi-annually, or at maturity. The Annual Percentage Yield (APY) represents the total interest earned over a year, accounting for compounding, where earned interest also begins to earn interest. This differs from the simple interest rate, which does not reflect compounding.

Early withdrawal penalties are imposed if funds are accessed before the maturity date. These penalties involve forfeiting a portion of the interest earned, often equivalent to several months’ worth. In some cases, a portion of the principal may be forfeited if accrued interest is insufficient. The specific penalty amount varies by institution and the CD’s term, with longer terms often incurring higher penalties.

Deposits in CDs are insured by federal agencies, providing security for the funds. The Federal Deposit Insurance Corporation (FDIC) insures deposits at banks, while the National Credit Union Administration (NCUA) provides coverage for credit unions. This insurance covers up to $250,000 per depositor, per insured institution, per ownership category. This limit applies to all accounts held by an individual at a single institution, not to each individual CD.

Exploring CD Variations and Their Specifics

Several types of Certificates of Deposit offer distinct features.

Callable CDs

Callable CDs grant the issuing bank the right to “call” or redeem the CD before its stated maturity date. This feature is often included when interest rates are expected to decline, allowing the bank to refinance at a lower rate. These CDs offer a higher interest rate to compensate the investor for this risk. A “non-call period” exists at the beginning of the term during which the CD cannot be called.

Brokered CDs

Brokered CDs differ in how they are purchased and traded. Unlike traditional CDs bought directly from a bank, brokered CDs are acquired through brokerage firms. While obligations of the issuing bank and FDIC-insured, they can be sold on a secondary market before maturity, offering liquidity not found in standard bank CDs. Selling on the secondary market may result in a gain or loss depending on prevailing interest rates.

Liquid, or No-Penalty, CDs

Liquid, or no-penalty, CDs allow early withdrawals without incurring a penalty, typically after an initial holding period, such as seven days from funding. This accessibility comes with a trade-off, as these CDs offer slightly lower interest rates compared to traditional CDs. While full withdrawals are permitted, partial withdrawals may not be allowed.

Step-Up CDs

Step-Up CDs feature an interest rate that automatically increases at predetermined intervals throughout the CD’s term. The schedule of rate increases is set when the CD is opened. The initial interest rate on step-up CDs can be lower than that of standard CDs, and the overall blended yield may not surpass traditional CD rates.

Jumbo CDs

Jumbo CDs are designed for larger deposits, typically requiring a minimum investment of $100,000, though some institutions may offer them with minimums as low as $50,000 or $95,000. These CDs may provide slightly higher interest rates than standard CDs due to the larger principal committed. Despite the higher deposit amount, they are still subject to FDIC or NCUA insurance limits.

Opening and Managing Your CD

Opening a Certificate of Deposit involves gathering information and making informed decisions. Compare interest rates and terms offered by various financial institutions to find a CD that aligns with your financial goals. Deciding on the appropriate term length is important, as longer terms may yield higher interest rates but entail a longer commitment of funds. Consider the investment amount, ensuring it meets any minimum deposit requirements, which can range from no minimum to $500, $1,000, or even $100,000 for jumbo CDs.

The process of opening a CD account, whether online or in person, requires providing personal details and identification. This includes your name, physical address, date of birth, and a tax identification number (e.g., Social Security number or Individual Taxpayer Identification Number). A government-issued identification, like a driver’s license or passport, is also required. Once the application is complete, the CD needs to be funded through various methods such as an ACH transfer, wire transfer, check deposit, or cash at a branch.

Upon reaching its maturity date, a CD offers several options. Many CDs feature an automatic renewal or rollover option, where the principal and accrued interest are reinvested into a new CD of the same term at the prevailing interest rate. Alternatively, you can withdraw the funds, including earned interest, without penalty during a grace period. This grace period lasts for about seven days following the maturity date and allows time to decide whether to renew the CD, withdraw the funds, or transfer them to another account.