Certificates of Deposit: What Is a CD Account?

A certificate of deposit, or CD, is a powerful financial instrument that's sometimes overlooked. Offering stable returns and competitive interest rates, CDs can serve as a strategic part of a diversified savings strategy.

Whether you're saving for a down payment on a home or simply building your nest egg, understanding the role CDs can play in a diversified portfolio is a great step toward making more informed financial decisions.

What is a CD account?

A CD is a type of savings account. But unlike traditional savings accounts—which allow you to withdraw funds at any time—bank CDs hold your funds for a set period, during which you can't access them without penalty.

This fixed term could range from a few months to several years, a duration you'll choose depending on your financial goals and needs. During that term, your money will earn interest at a stable pace.

How does a CD work?

Think of CDs as a timed safe for your money. In exchange for leaving a lump-sum deposit untouched with your bank, you receive a competitive, fixed interest rate that's often much higher than what a standard savings account might offer.

Essentially, you're trading immediate access to your money for the assurance of its growth—a financial commitment that often proves advantageous for your future.

The benefits of CDs

Not only do CDs typically carry attractive interest rates, but the rates are locked in for the duration of the term. This ensures you know exactly how much your money will grow over time, providing a clear picture of your financial return. 

As with other types of high-yield savings accounts, CDs can be particularly appealing during periods of high interest. As interest rates on credit rise, so do the rates offered on new CDs. By locking in a bank CD at a higher rate, you're securing a return that won't be affected if rates subsequently fall.

CDs and FDIC insurance

While CDs don't have the growth potential of stocks, they offer something stocks famously lack—predictability. When opened through a bank that's insured by the Federal Deposit Insurance Corporation, or FDIC, your investment in a CD is protected up to $250,000 per depositor, per insured bank, for each account ownership category.

This means that even in the unlikely event of a bank failure, your money up to $250,000 is safe—including money invested in a CD. And if you adopt strategies for maximizing FDIC insurance, you may be protected even further. This level of security is not found in most investment vehicles, making this one of the most significant advantages of a CD.

How to open a bank CD

Similar to opening a traditional bank account, opening a CD is typically a straightforward process. In most cases, CDs can be opened by visiting a branch location. If you prefer to manage your own finances, some banks will also let you open a CD account online. Keep in mind that most banks offer a variety of CD terms, and the right choice will depend largely on your personal financial goals. You may find it helpful to consider the following factors before opening a bank CD.

Evaluate your personal liquidity

Before investing in a CD, carefully evaluate your personal liquidity and consider how long you can go before you'll need access to your funds. If there's a chance you'll need to withdraw funds soon, you might look for a bank CD with a shorter term or explore another type of high-yield savings vehicle, such as a money market account.

Choose your CD term

The timeframe of a CD, also known as its term length, is how long you agree to leave your money deposited with the bank. CD terms can range from 3 months to 5 years, allowing you to choose a duration that aligns with your financial goals.

Short-term CDs can be well-suited for more immediate savings goals, while longer terms can help contribute to more distant objectives, such as saving for a down payment on a home. Depending on the rate environment and other factors, longer terms may offer higher interest rates to reward you for your patience and commitment.

Consider the rate environment

When weighing the pros and cons of CDs, it's helpful to keep an eye on the economic forecast. When interest rates are low, other types of investments may potentially offer a better return. During periods of high interest, a CD may allow you to secure a favorable rate that might not be available in the future.

Examine your risk tolerance

CDs offer stable returns, but this security comes at the cost of potentially higher gains from investments with variable returns, such as stocks and mutual funds. As a result, it's important to carefully evaluate your risk tolerance and investment timeline. If the peace of mind from a guaranteed return aligns with your financial outlook, CDs may be a favorable option.

On the other hand, if you're willing to assume more risk for the chance of greater returns, diversifying your portfolio to include some variable-return investments like stocks and bonds may be appropriate. If you're unsure which option fits your goals, consider working with a financial advisor.

Be mindful of early-withdrawal penalties

It's important to know that federal law sets a minimum penalty on early withdrawals from certificates of deposit. If you need to withdraw funds from your CD before it matures, expect to pay a penalty equivalent to several months' worth of interest. This forfeited interest will be deducted from the principal balance you withdraw.

CD savings strategies

Depending on your objectives, utilizing CD investing strategies may be a powerful way to balance growth and liquidity while fine-tuning your savings plan.

CD laddering is a popular option due to its versatility. By staggering your savings across multiple CDs of varying term lengths, a CD ladder may help you capitalize on higher interest rates while maintaining timed access to a portion of your funds. This strategy may be appropriate for a variety of objectives and circumstances—from retirees using CDs for retirement income to young professionals juggling multiple savings goals.

Other popular strategies include a CD barbell and a CD bullet. The barbell strategy involves splitting an investment into two CDs: one short term and one long term. This strategy can be useful if you want to lock in an attractive long-term rate while keeping a portion of your funds accessible for short-term needs.

A CD bullet involves investing in multiple CDs at different times, but all have the same target maturity date. This strategy is ideal for date-specific goals, like saving for a wedding. It may also be a good option for those who'd like to gradually contribute more funds over time.

CDs versus high-yield savings accounts

As with any type of investment strategy, diversification is key. Rather than putting all your funds in a CD versus a high-yield savings account, explore the benefits of both. CDs often complement the flexibility of savings accounts, allowing you to take advantage of more favorable interest rates while maintaining access to some of your funds for any short-term needs.

This strategic allocation allows you to benefit from the compounded growth of a long-term deposit and the convenience of available cash. Balancing your money across both types of accounts may help ensure that you're prepared for both planned and unplanned financial events.

Key takeaways

• CDs offer stable returns and competitive interest rates and can be a particularly appealing investment in a high-rate environment.
• Depending on your goals, there are multiple CD savings strategies you might wish to employ. These include a CD ladder, barbell or bullet.
• Before investing in a CD, consider your liquidity needs, financial goals and appetite for risk. This can help you determine the best CD term for your needs.