How to Use Certificates of Deposit to Make Money

Certificates of Deposit (CDs) offer a straightforward, low-risk way to grow savings. These financial products provide predictable returns, making them an attractive option for those prioritizing stability over market volatility. Understanding how CDs function and the steps involved in investing can help individuals utilize them to generate money.

Understanding Certificates of Deposit

A Certificate of Deposit is a type of savings account where a fixed sum is held by a financial institution for a predetermined period, earning a fixed interest rate, and requires funds to remain deposited for the entire term to avoid penalties.

CDs have a fixed term, ranging from three months to five years or longer. Early withdrawals typically incur penalties, often a forfeiture of earned interest. The fixed interest rate is set at the time of deposit and remains constant throughout the term.

Upon maturity, the principal and earned interest become available. Investors can withdraw funds or roll them over into a new CD. Deposits in CDs at federally insured banks are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per depositor, per institution. Credit union deposits are insured by the National Credit Union Administration (NCUA) up to the same limit.

Key Elements of CD Investments

The interest rate and the Annual Percentage Yield (APY) are key measures of return. The interest rate is the nominal rate, while the APY provides a comprehensive measure by incorporating compounding interest over a year. A higher APY means more money earned.

Longer CD terms, such as those extending several years, generally offer higher interest rates than shorter terms. Financial institutions reward investors for committing funds for extended periods. However, market conditions, like an inverted yield curve, can sometimes lead to shorter terms offering comparable or higher rates.

Beyond traditional CDs, various types exist:
Jumbo CDs require a larger minimum deposit, often $100,000, and may offer higher interest rates.
Brokered CDs are purchased through brokerage firms, offering access to multiple banks and competitive rates. They can be traded on a secondary market, allowing for liquidity before maturity, though their market value can fluctuate.
Callable CDs offer higher interest rates but allow the issuing bank to redeem the CD before maturity, typically if interest rates decline.
Step-up or Bump-up CDs allow for interest rate adjustments during the term, providing an opportunity for increased earnings if market rates rise.

Navigating the CD Investment Process

Prospective investors should compare rates and terms across various financial institutions, including traditional banks, credit unions, and online banks. Online banks often provide competitive rates due to lower overhead costs. For brokered CDs, investors typically work with a brokerage firm to access offerings from multiple issuing banks.

When comparing CD offers, it is important to focus on the Annual Percentage Yield (APY) and minimum deposit requirements. Note any early withdrawal penalties, which can reduce returns if funds are needed before maturity. Penalties are generally a forfeiture of interest, but can sometimes affect the principal.

To open a CD account, individuals need to provide personal identification, such as a driver’s license, and their Social Security or Taxpayer Identification Number. Fund the account through electronic transfers or by mailing a check. Opening a CD account can be completed online, in person at a branch, or through a brokerage firm.

Optimizing Your CD Returns

One widely used approach is CD laddering, which involves dividing a lump sum of money into several CDs with staggered maturity dates. For example, an investor might purchase CDs maturing in one, two, three, four, and five years. As each shorter-term CD matures, the funds can be reinvested into a new long-term CD to take advantage of potentially higher rates. This strategy balances liquidity, as a portion of funds becomes available regularly, with the benefit of earning higher long-term rates.

At maturity, investors have options: reinvest the principal and earned interest into a new CD or take a payout. Reinvesting allows for compounding, where previously earned interest begins to earn interest itself, leading to greater overall returns. Compounding interest, whether daily, monthly, or quarterly, contributes to the investment’s growth.

Interest earned from CDs is generally considered taxable income. This interest is subject to federal income tax, and in many cases, state and local taxes. Financial institutions report CD interest earnings to the Internal Revenue Service (IRS), and investors receive a Form 1099-INT for amounts of $10 or more. The interest is taxed as ordinary income in the year it is earned, even if not withdrawn but reinvested. For CDs with terms longer than one year, taxes are owed on the interest accrued each year. Holding CDs within tax-advantaged retirement accounts, such as an Individual Retirement Account (IRA), can defer taxes until distributions are taken.