What is a Certificate of Deposit? Overview, Types, Calculator, Example
A certificate of deposit (CD) is a type of savings account that holds money for a period of time with a fixed interest rate. They’re a safer investment than stocks and bonds, with a non-volatile, guaranteed rate of return. Let’s take a look…
What is a Certificate of Deposit (CD)?
A certificate of deposit (CD) is a bank account that pays you a higher interest rate in return for locking your money away for a fixed period of time. Terms generally range from three months to five years. Generally, the longer the term, the higher the interest rate. Similarly, penalties for early withdrawal tend to be higher as the term lengthens. In return, the issuing bank pays interest. You agree to not touch the CD funds for a set period of time until you reach the maturity date. When you cash in or redeem your CD, you receive the money you originally invested plus interest.
Here are some terms you might see with a certificate of deposit…
- Interest Rate – An interest rate for a CD is a fixed, locked rate. It provides a clear and predictable return on your deposit over a specific time period.
- The Principal – The initial deposit when you open the CD.
- Early Withdrawal Penalty – A charge incurred for early withdrawals from a CD before the maturity date.
- Maturity Date – The date when your CD matures and you can withdraw funds without being penalized.
- Term – This is the length of time you agree to leave your funds deposited to avoid any penalty. In most cases, it is measured in months. The term ends on the maturity date, and you can withdraw your funds without penalty.
- Add-to option – Add-to options allow you to make additional deposits to your CD after it has been opened. Your savings earn more interest, but the additional amount added to the CD is locked in for the duration of your CD.
CDs are issued by banks, credit unions and some financial entities. They’re backed by the FDIC up to $250,000. This means you’re guaranteed money back if a financial institution goes bankrupt. They’re a virtually risk-free investment compared to stocks and most bonds.
Types of Certificates of Deposits
Not all CDs are alike. Here are some different types of CDs…
- Fixed-Rate CD – a traditional CD with a set interest rate over its entire term.
- Step-up CD – A step-up CD comes with regularly scheduled interest-rate increases. This is so you’re not locked into the rate that was in place at the time you bought your CD. Increases usually happen every 6 months.
- Liquid CD – A Liquid CD allows you to withdraw funds early without paying a penalty. You’re able to move your funds to a higher-paying CD if the opportunity arises. But liquid CDs pay lower interest rates than a traditional CDs.
- Bump-up CD – A bump-up CD is a certificate of deposit that allows the holder to take advantage of increasing interest rates. This is so you don’t get stuck with a low return if interest rates rise after you invest. Usually, this is permitted only once.
- Jumbo CD – A jumbo CD requires a higher minimum principal than what’s required by traditional CDs.
You can typically get better interest rates than a savings account would provide without the risk of investing in the stock market. Let’s look at the differences…
The Difference Between Savings Account and Certificate of Deposit
A savings account is a bank account that typically earns interest. Depending on your bank, you may be able to withdraw money as often as you need. Many banks limit certain withdrawal types to around six per month. If you exceed the limit, the bank may charge you a fee of around $5 per extra transaction. Banks may close accounts or convert them to checking accounts if they receive repeated excess withdrawals.
A certificate of deposit is a special savings account you can open at most banks and credit unions. It requires you to lock away your money for a defined period of time, unlike a regular savings account. CDs earn a higher rate of return than a standard savings account in most cases. Interest rates are usually fixed. This unique feature makes CDs perfect for certain long-term savings goals. They offer higher interest rates than savings accounts without the risks associated with stock market investments.
You can use the Investment U CD calculator to find out how much interest is earned on a certificate of deposit (CD). As you enter the variables, the CD calculator automatically updates. You’ll see how the investment and interest compound each year.
Certificate of Deposit Example
David invested $10,000 in CD with a bank at a fixed interest rate of 5%. The term of maturity was 5 years. The returns and maturity value of the CD are calculated as follows…
When the loan matures, he will get back his initial investment of $10,000 as well as interest. The return on the CD for the period of five years is $2,763. David’s maturity proceeds total to $12,763.
The Final Line
A certificate of deposit can be a great way to grow your investments risk-free. But they’re not for everyone. You should always do your own research before investing. However, if you have some extra cash that you want to put away and earn interest on, a CD could be perfect for you.
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About Aimee Bohn
Aimee Bohn graduated from the College of Business and Economics at Towson University. Her background in marketing research helps her uncover valuable trends. Researching IPOs and other trends has been her primary focus over the past year. When Aimee isn’t writing for Investment U, you can usually find her doing graphic design or traveling with friends.