If you want your money to work a little harder but aren’t so sure about investing in stocks or bonds, look into a certificate of deposit (CD). With a CD, you can earn peace of mind (oh, and savings) if you’re able to lock in your CD rate for a fixed term. Since it’s easy to estimate your earnings, a certificate of deposit could be just what you’re looking for to help you manage and plan for your future.
Some people use the earnings from a CD to supplement their Social Security and retirement income later in life. Others use a series of CDs, called a CD ladder, to store an emergency fund to earn more interest than they could with a checking or savings account.
So, how to open a certificate of deposit? The process can be similar to opening a checking or savings account. However, there are more moving parts to keep in mind. If you’re considering opening a certificate of deposit, consider these six steps:
- Find an insured financial institution. The Federal Deposit Insurance Corporation (FDIC) and National Credit Union Administration (NCUA) insure banks and credit unions, respectively. If you open a certificate of deposit, you can sleep easily at night knowing that if an insured bank or credit union fails, you will be protected by insurance to the maximum allowed by law.
- Pick a type of CD. A certificate of deposit isn’t necessarily one-size-fits-all, and there are many different types of CDs to choose from. You’ll need to decide which type to open and find a bank, credit union or broker who can sell it to you.
- Choose your term. When you open a certificate of deposit, one of the first things you’ll need to choose is the length of your term. “The longer the term length, which means the longer you commit to keeping your money in the account, the higher the interest rate you’ll earn,” says David Niggel, a certified financial planner at Key Wealth Partners, LLC in Lancaster, Pennsylvania.
- Decide how often you want to collect your interest payments. With your payout, you’ve got options: You may be able to receive your interest as a monthly payment or once annually. You can also reinvest the interest payments into the CD to earn compounding returns. Once the CD’s term ends, you’ll get your initial deposit back, along with your final interest payment.
- Create your account. Unless you already have one, you’ll need to create a new account with the issuing bank or credit union to open a certificate of deposit. You may have to share personal information such as your name, address, contact info and tax identification number (such as a Social Security number).
- Fund the CD. You’ll also need to choose a funding source for your new CD account, such as an online or phone transfer, or mailing a check.
Comparing CD types and features
After learning how to open a certificate of deposit, you may want to review the different types of CDs to see which one best fits your financial goals. Hint: Take a look at the factors that can impact a CD’s interest rate.
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A traditional CD has a fixed term and interest rate, but that doesn’t have to be the case. For example, you may be able to open a variable-rate CD, and its interest rate could go up or down over time. Other types of CDs include:
- Liquid or no-penalty CD. The interest rate could be a little lower than what you’d receive on a traditional CD, but in exchange, you can withdraw some of the funds without paying a penalty.
- Callable CD. The interest rate might be higher than a traditional CD’s, but the issuer can “call” the CD—cut the term short and cancel future payments. They’ll need to pay you the interest owed so far, but that’s the end of the agreement.
- Bump-up or adjustable-rate CD. Some CDs come with an option to request an interest rate adjustment if rates rise in the future. You may only be able to make the request a limited number of times. If interest rates go down, an adjustable-rate CD’s interest rate may also drop.
There are also some common features that could vary depending on the issuer and type of CD. Here are a few to consider when you open a certificate of deposit that may affect your earnings or expenses:
- Interest rate and APY. Similar to other types of savings accounts, the CD’s issuer will pay you interest on the money in your account. If you’re thinking about opening a CD and are comparing different accounts, pay close attention to the annual percentage yield (APY). The CD’s APY takes compounding into account and lets you know how much you could earn per year. “Keep in mind that you will be responsible for paying taxes on any interest generated each year by the CD,” says Helen Ngo, principal of the independent financial planning firm Capital Benchmark Partners, LLC in Atlanta.
- Term. When opening a certificate of deposit, you may be able to choose a term of less than a month to a decade or more. Generally, the longer the term, the higher the CD’s interest rate.
- Minimum deposit requirements. Some CDs have a minimum funding requirement, and you’ll need to deposit at least that much money to open a certificate of deposit.
- Early withdrawal penalty. After opening a certificate of deposit, you’ll need to be hands-off with your funds for the specified term. However, with a penalty, you may be able to withdraw your money early. The penalty could be several months’ worth of interest and could offset or completely negate your earnings.
- Other fees. They may be less common, but you should be aware of these fees if you’re thinking about opening a certificate of deposit. Some CDs may have monthly or annual maintenance fees, for example. In addition to an early withdrawal penalty, withdrawal or transfer fees may be applied by some issuers. There are also brokers that charge you a fee if you purchase a CD through them.
Understanding the risks
While CDs can be a relatively safe way to grow your savings, there are some risks when you open a certificate of deposit. Liquidity risk—the risk that you’ll need the money when it’s locked up in a CD—is an important one.
Ngo doesn’t recommend opening a certificate of deposit if you think you’ll need the funds in less than a year. You can always consider putting short-term funds in an online savings account, where you can earn interest and ditch the concern about liquidity.
However, Ngo adds that as long as you have an emergency fund, “if you will not need the cash for two to five years, a CD is a great option if you are afraid to invest it in the market or in bonds.”
There’s also a risk that interest rates rise in the future. If that happens, your money could be locked in a CD and earning you less interest than you’d get from a savings account.
Building a CD ladder could help you minimize liquidity and interest rate risk. That means rather than buying a single CD with $10,000, you could buy four $2,500 CDs with one-, two-, three- and four-year terms. Each year, one of your CDs will mature. If you need the money, you’ll be able to take it out of your ladder without paying a penalty. Alternatively, you can reinvest the funds in a new four-year CD and get an interest rate that’s higher than what you’ll find on a one-year CD.
Safety, certainty and more earnings—is a CD right for you?
While there are some risks involved with any investment, opening a certificate of deposit can be a safe way to grow your savings. “If the money to be invested is needed within a certain time frame, a CD can fit your schedule,” Niggel says. He calls them a “low-risk and low-expense savings tool. ”
Whether you’re building your savings for a short-term goal or looking to increase your fixed income, now that you know how to open a certificate of deposit, you can add this financial tool to your repertoire of options.