What is a CD?
Certificates of deposit, commonly known as CDs, are time-bound investments that require you to deposit a sum of money for a fixed amount of time, ranging from a few months to several years.
They are safe investments, insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000 per depositor, per bank. CDs are a perfect investment option for those looking to earn higher interest rates without incurring risks associated with the stock market.
How do CDs work?
CDs work by depositing a sum of money with a bank for a set period and earning interest on that money. The interest rate on CDs varies based on the term or length of the CD. Terms can range from as little as three months on the short end to as high as seven years or more on the long end.
Terms lengths of CDs
Generally, longer-term CDs tend to offer higher interest rates than shorter-term CDs. The interest accrues monthly or annually, depending on the terms of the CD. If you withdraw your money before the CD matures, you might be charged a penalty.
CD maturity
When you reach the end of the CD term, the CD is considered matured and you may withdraw the funds or place them into a new CD as you see fit. Typically, longer-term CDs offer higher interest rates, but this depends on the bank.
CD interest rates
Interest rates are usually locked in for the full length of the CD term, which can be a good or a bad thing, depending on what rates are doing at the time.
If rates are decreasing, locking in your CD rate can be a good thing, because it means you can earn a higher interest rate than you with a high-yield savings account, for example, where interest rates can fluctuate. But if you open a CD when rates are rising, you could get stuck earning a lower interest rate.
CD ladders
To combat this risk, some people employ a CD laddering strategy. To do this, you break up the amount you were going to invest in a single CD into chunks and invest them into CDs of differing lengths. For example, you could break up $5,000 into five $1,000 chunks and invest one chunk each in a one-, two-, three-, four-, and five-year CD.
When the one-year CD matures, you place that money in a new five-year CD, then do the same thing the next year with the two-year CD, and so on. This enables you to take advantage of higher interest rates on longer-term CDs while still giving you access to some of your money every year.
How interest is paid
Interest is usually paid monthly or quarterly, and some banks let you decide if you want the interest paid directly to you or added to the CD. Keeping the money in your CD is your best option if you're trying to earn the most money overall, because when you earn the next interest payment, it'll be on your new, larger balance.
Taxes on CDs
Your CD earnings are taxable, even if you cannot actually spend those earnings yet. Your bank or credit union will send you a 1099-INT form by January 31 of the next year if your CD earned at least $10 in interest during the year. If not, you still owe taxes on the interest, but you are responsible for reporting those earnings yourself.
Automatic renewal
Once your CD term is up, your bank may choose to place the funds in a new CD automatically if you don't give it other instructions. This is usually a bad option, because the CD the bank chooses might not be the best one for you at the time.
So before your CD term is up, you should instruct the bank on what CD you'd like to place your money in, or whether you'd like the money paid to you.
Withdrawing money from CDs
If you withdraw the money before the CD term is up, you will pay a penalty. This penalty is usually equivalent to one or more months of interest, but it depends on the CD you choose and how early you withdraw the funds. Some banks may also impose a minimum penalty. You must withdraw all of the funds in the CD at once -- you cannot leave some there to continue earning interest.
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