What is a certificate of deposit?

Few people will turn down the opportunity to earn interest on their money — especially if they can access guaranteed interest rates higher than most traditional types of bank accounts provide. Interest is essentially money you can use to pad your emergency fund or save for a rainy day, and you don’t have to work to earn it.

While many investment options allow you to put your money to work, few offer the security of a certificate of deposit (CD). If you purchase a certificate of deposit through an FDIC-insured bank, the Federal Deposit Insurance Corp (FDIC) insures your money for up to $250,000. That’s something you won’t find through equity investments like stocks.

Of course, before you head to your nearest bank and open a certificate of deposit, you’ll want to understand what they are and how they can benefit you. Everyone’s financial circumstances are different, so it’s best to do some research before taking the CD plunge.

How does a certificate of deposit work?

Think back to your childhood and how you saved for big-ticket items your regular allowance didn’t pay for. Maybe an authority figure, like a parent, told you to keep your money in a piggy bank until you had enough to buy that video game or ten-speed bike.

You’d deposit any money you earned from chores or babysitting your little sister into the jar until you racked up enough money to make your purchase. If you were lucky, your parents promised to match your savings with a little extra so you could meet your goals earlier.

A certificate of deposit is a little like your childhood piggy bank, with a few key differences.

When you put your money in a certificate of deposit, you commit to keeping it there for a set period. Most certificates of deposits, or CDs, have time limits from six months to five years. Your money will stay in the account until the period ends.

Of course, if something comes up and you need to access your funds early, you can do so — but you might incur unwanted fees. Your financial institution can explain any fees they apply to early withdrawals.

Another critical difference between your piggy bank and a CD is safety. While you hoped no one would touch your carefully maintained savings in your childhood piggy bank, there was no guarantee your older brother wouldn’t “borrow” a few dollars to pay for a date or some baseball cards. If someone took money from your piggy bank, it was your word against theirs, so you could easily lose some of it.

That isn’t the case for a CD. Once you deposit money in a CD, the FDIC protects your funds. As long as you have $250,000 or less in all your accounts with your selected bank, you don’t need to worry about someone stealing your money.

You also don’t need to worry about bank closures. If your bank goes belly up, the FDIC will ensure you get your money back.

Finally, your CD will accumulate interest. Interest rates can be fixed or variable, depending on the terms of the CD. Your bank might pay you interest monthly, semi-annually, or some other frequency.

Basically, you’re guaranteed to earn some money on your deposit. It won’t sit there, earning nothing like it would in your childhood piggy bank.

What are the benefits of a certificate of deposit?

Putting your money in a certificate of deposit comes with a few strategic advantages.

Most banks tie their CD offerings to fixed interest rates. A fixed interest rate promises you specific earnings throughout your investment. In fact, you’ll know exactly how much you’ll earn when you review your CD’s contract.

That’s quite different from the stock market, where no guaranteed earnings exist. Purchasing stock in a company could lead to gains and dividends over time, but it could just as easily result in a loss.

Some banks use variable interest rates for their CDs, so it’s essential to examine the terms and conditions before you decide to go with a CD. Variable interest doesn’t mean you won’t earn money, but it does mean that the rate could go up or down over time, so your future earnings won’t be set in stone.

Another benefit of CDs is lower market risk. Your earnings won’t be as volatile as other investment options. For instance, if the economy suffered a deeper downturn, you wouldn’t need to worry about the value of your CD falling. It would stay the same, still trucking along and earning interest.

CDs are one of the safest investment alternatives available. That makes them highly attractive to people who can’t afford to lose their money in investments or simply want to rest easy at night, knowing their cash is secure.

What are the risks of a certificate of deposit?

Even though CDs are often highly attractive investments, there are a few disadvantages to certificates of deposit to be aware of.

Perhaps the biggest drawback is limited access to your money. Most banks will charge you an early withdrawal penalty if you pull out your money before the CD’s term ends. They might charge you additional fees, too. It all depends on the terms of your contract — so you’ll want to read it thoroughly before you purchase a CD.

Limited access to your funds might not be a big issue if you have money stashed elsewhere. For instance, if you have a savings account, or emergency fund, or can meet an unexpected expense with your paycheck, you might not worry too much about being unable to withdraw your money. However, weigh your ability to cover unexpected costs when deciding on how much to put in a certificate of deposit. If you deposit too much and then need to make a withdrawal, you’ll cut into your earnings and incur penalties.

Finally, you might miss out on future earnings if you place your money in a long-term CD and interest rates rise. For example, putting $5,000 in a 4% APY CD for five years might sound like a pretty good deal. However, if interest rates jump to 6% in six months, you’re locked into a CD that won’t earn as much money as newer ones.

You can mitigate your risk of missed returns by following a laddering strategy. In a laddering strategy, you invest your money in CDs with different durations. For instance, you might invest in a six-month and one-year CD. When your six-month CD matures, you could reinvest your money in a new CD to take advantage of higher rates if they increase.

Who should consider a certificate of deposit?

If you’re looking for a secure way to earn a fixed amount of money on your savings, you can’t go wrong with a CD. They are ideal for people with specific short-term goals, such as planning a major vacation or saving for a down payment on a home. While the earnings potential for a CD is generally less than other investments, such stocks, there is also far less risk.

People close to retirement might prefer CDs over other investments simply because of their security. Once you near your retirement years, you might be more risk-averse regarding your finances. Recovering from losses on more volatile investments can take longer and significantly impact your ability to retire or fund your lifestyle. With a CD, you don’t need to worry about market volatility.

Everyone’s personal financial circumstances differ, so consider your goals and risk tolerance when deciding whether to open a CD. It might not have the familiar features of your childhood piggy bank, but it can provide guaranteed earnings and safeguards that protect your money.

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A CD is a great option, but it’s just one part of a comprehensive financial plan for the future. Life insurance is another. Haven Life offers affordable term life insurance for people who want to safeguard their loved one’s future financial stability.

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