If you are reading this, it means you have a sum of money that you’d like to set aside for some time. Money is an important asset that should be handled with the utmost security.
Financial institutions offer various packages concerning investments and savings. Hence, the importance of understanding what each of these options offers can not be overstated.
What is a CD?
Have you ever had a piggy bank? If you haven’t, you’ve probably heard of it anyway. Piggy banks are designed to be a “foolproof” method of saving. There’s a single small entry that’s just wide enough for you to insert your money, but too small to let the money slip out.
The only way to have access to your money is by breaking the piggy bank.
Well, a Certificate of Deposit (CD) is just like a piggy bank, except you get even more money than you saved in the first place. And you can ‘break your money out’, but with a fee.
CDs serve as a means of safely locking your money away for some time while earning you interest.
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What is the difference between a CD and a savings account?
A savings account offers a much lower interest rate than a CD and also allows you to withdraw your money at any time without extra charges. A CD, on the other hand, offers a higher interest rate in exchange for the safekeeping of your money for the agreed duration of the term. A CD has only one official penalty-free withdrawal date. This is known as the Maturity Date.
Premature withdrawal attracts a penalty of 3 – 12 months interest, depending on the duration of the term and the amount of time left.
How do CDs work?
CDs are purchased directly from an issuing bank, credit union, or brokerage firm. They are available in several denominations and currencies.
After purchasing a CD at a certain price (the amount of money you intend to save), the term is agreed upon. A CD term can range from months to years, during which you cannot withdraw your money. A longer-term attracts a higher interest rate.
On the maturity date, the interest is paid and you can receive disbursement (interest earned plus the original amount) via a cheque. You can either withdraw the money, move it to your savings or checking account, or renew your CD.
Renewing your CD will introduce you to the concept of Compound Interest. This will be further discussed below.
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Some terms to be familiar with when dealing with CDs
Although some terms have already been defined, here is a list of terms that are bound to come up in any CD related discussion:
- Maturity Date: This is the set date that rounds up the CD term. You can take your money out of the CD without restrictions or penalties.
- CD Term: The CD term is the period for which you will not have easy or unrestricted access to your money.
- CD Rate: This is the premium fixed rate of interest that is paid according to the deposit and CD term.
- Annual Percentage Yield (APY): APY refers to the total amount of interest you earn annually. It takes into account the interest rate and compounding interest. There are several APY calculators on the internet, however, you can also calculate it by yourself to be certain.
The standard APY formula is: APY = (1+ rn )ⁿ – 1
Where r = interest rate
And n = number of compounding periods per year
- Compound Interest: After the maturity date, you can decide to either withdraw your money or reinvest it into your CD account. The new amount invested will be the sum of your principal and the interest earned. This new figure will start to earn an interest of its own, greater than the previous. Compound interest is, therefore, the total amount of interest incurred on your principal after subsequent renewals of the CD.
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Types of CDs
There are several types of CDs based on different principles. These include:
Traditional CD: The traditional type of CD involves you depositing a fixed amount of money for a certain period in exchange for a fixed interest rate. Withdrawal is restricted and attracts penalties.
Liquid CD: The interest rate is lower than the traditional CD rate because of the withdrawal conditions. There is no penalty for premature withdrawal, however, it is usually a game of All or Nothing. Most banks insist that, if you have to withdraw before the maturity date, you should withdraw all your money.
Brokered CD: This CD is offered through a broker or brokerage firm. Brokers serve as agents or sales representatives that help you find the best interest rates in the finance industry.
Step-up CD: As the name implies, Step Up CDs automatically increase rates (whenever market rates rise) throughout the term.
Callable CD: When you purchase this type of CD, you get a Call-protection period. This period keeps your CD rate constant. However, once that period expires, the CD rate becomes subject to change. If there is a drop in interest rates, your bank can call your agreed-upon CD rate away which will lead to an equal drop in the CD rate.
High Yield CD: This CD operates the same way as a traditional CD but may offer about 2-3 times the average CD rate.
Variable Rate CD: There is no fixed interest rate. The CD rate is fluid and changes over time according to the market rates or the federal funds rate.
IRA CD: The CD serves as an Individual Retirement Account (IRA). You can invest a lump sum of money towards your retirement plan. This type of CD comes with FDIC (Federal Deposit Insurance Corporation) protection so you don’t have to worry about losing your money, even if the bank goes bust.
Jumbo CD: This is meant for larger deposits. Usually, a minimum of $100,000 is required to open this account. The CD rates are a bit higher than ordinary CDs of the same duration.
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How do banks set CD rates?
There are several factors that banks and other financial institutions take into consideration before setting CD rates. Some of these include:
- The CD Term:Long CD terms give the financial institution more flexibility with your money. They can invest and make deals that would fetch them huge profits. Because of this, long-term investments attract higher interest rates. Typically, CD terms range from a period of 3 months to 10 years. The CD rate given to a 1-year CD deposit will be significantly higher than a 3-month deposit.
- The Amount Invested: The amount of money invested is equally important in determining CD rates. More money is always greatly appreciated. A $100,000 deposit will earn higher interest than a $10,000 deposit. Deposits that exceed a certain amount of money ($250,000 or $500,000) may attract special CD rates.
- Current Interest Rate Environment: Interest rates are influenced by the Federal Funds Rate. If this benchmark rate rises, bank rates, and CD rates would also rise.
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Should you purchase CDs from your local bank or credit union?
A credit union is a non-profit financial institution that was designed to connect people who share a common financial bond. Some credit unions offer special and competitive APYs on CDs. While it is normal and recommended to go with the institution that offers the highest interest rate, it is also important to go with the one you are most comfortable or familiar with. Credit unions and banks are equally safe and have reasonable rates.
Building a CD ladder is a smart tactic for protecting against rate changes over time and also maximizing return. Because the interest rate increases as the CD term extends, individuals prefer long-term CDs. However, not everyone has the patience to wait for 3-5 years before withdrawing a bulk of the money.
A ladder has several steps that take you to the top. Instead of taking one large step by depositing a huge amount of money into a long-term CD account, you can apply the CD ladder strategy and reach your goals faster.
If your initial plan was to deposit $100,000 into your CD account, you can break that sum of money into five places and purchase five different CD accounts. This means that you can purchase five $20,000 CD accounts of varying lengths. Your total CDs will now include: $20,000 1-year CD, $20,000 2-year CD, $20,000 3-year CD, $20,000 4-year CD, and $20,000 5-year CD.
These accounts form a 5-step ladder which will fetch your interest and maturity dates every year for five years. Although technically, you are still waiting for 5 years (since you also purchased a 5-year term CD), it wouldn’t feel like it because you would be receiving interest annually. In the long run, the cumulative interest from each term will be greater than the 1-time projected interest on a $100,00 5-year CD.
Are you ready to open a CD account?
Do you need to purchase a CD or should you stick to your savings account?
A CD is an awesome way of saving your money while earning interest at the same time.
However, it is not the best choice for everyone.
CDs are ideal for people who have extra money and can afford to set it aside for a long time without touching it. In this case, they are certain they have enough money to meet their needs for a while and also have emergency funds.
While a CD can serve as savings for plans such as college funds, retirement plans, or other investments, it should never be used as an emergency fund. Emergencies are unpredictable and require quick action. You will not have the luxury to rush to the bank and demand your money immediately – even if you are willing to pay the penalty. CD withdrawals usually require days or weeks to process.
Do you think you’re ready for a CD account? What do you think about the CD ladder? Are you going with your local bank or credit union? Let us know in the comment section and feel free to ask more questions!
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