Understanding Certificates of Deposit

Reviewed: February 21, 2014
By FinanceWeb

A CD, or certificate of deposit, is an interest-bearing account offered by most banks and other financial institutions. As a savings account that offers a pre-determined interest rate, CDs represent a safe way to achieve short-term gains with practically no risk. The interest rates offered for CDs are usually higher than the bank’s other checking and savings options. However, a CD comes with its own set of guidelines that differ from other bank products. These guidelines govern how the account works, and what depositors can expect from it.

CD Basics

Many people walk into their bank or credit union every day and notice the list of bank products posted up on the wall. That list will show the types of services the bank has, as well as the interest rate associated with those service. The highest interest rate is usually reserved for the bank’s CDs. Unlike some other financial products, a CD represents actual money in the bank; it’s not a security or a stake in something else. That means the funds are not open to risk, and they are also FDIC insured. These are some of the main reasons why CDs appeal to people.

How CDs Work

A certificate of deposit comes with its own set of rules and regulations that governs how it works. Understanding these things is the key to using a CD properly. Many people notice the CD rates and want to dump money into them. This is before they realize that those good rates come along with certain rules that they need to follow, and penalties they can face.

A CD is a time deposit. That means that people allow the bank to hold onto their money for a set amount of time. During that time, the money will accrue interest until it reaches maturity. Once matured, the depositor can withdraw the funds and interest, or they can choose to add the new, greater amount into another CD. Certificates of deposit have a set time limit. Usually, the longer you agree to keep your money in the CD, the higher the associated interest rate. People can choose terms that last anywhere from six months to five years. There are also varying terms that can last for as little as one month and as much as ten years.

Penalties

Penalties usually come with early withdrawals. When someone attempts to make a withdrawal of their funds before they mature will receive penalties. The penalties vary from bank to bank, and some are harsher than others. CDs are not withdrawal accounts, they are savings accounts. However, sometimes money can become necessary for whatever reason, and an early withdrawal can help. Those that use CDs need to make sure they understand what penalties are involved with their CD accounts.

Types of CDs

The basic way that a CD works goes more or less unchanged no matter what type of CD a person invests in. Many banks like to change the rules a little or call their CD products by different names. In essence, they typically all work the same, but have different types of withdrawal rules, varying interest rates, minimum balances and penalties associated.

Some of the terms that banks and other financial institutions use include:

  • Small CDs
  • Large or Jumbo CDs
  • No-penalty and Liquid CDs
  • Variable and Bump-up CDs
  • Callable CDs

There are also other types of CDs as well. It’s a flexible product, and many banks like to give their CD products their own proprietary names. The important thing for anyone that wants to open a CD account is to make sure that they understand the rules for any given type of CD, and the penalties involved.