Certificate of Deposit (CD): Benefits & How They Work

The best way to think of a Certificate of Deposit (commonly known as a CD) is as a contract between you and a bank: you agree to give the bank a certain amount of money for a specified period of time, and the bank agrees to pay you a certain amount of interest for that time frame.

CDs can be a great way to match savings with financial needs that you anticipate within the next few years. They are also useful for locking in an interest rate if you think market rates are about to fall.

Basic Features of a CD

By understanding some of the basic features of CDs, you may be able to put them to best use for your financial goals:

FDIC protection

CDs are among the deposits that can qualify for FDIC insurance protection. To ensure that this applies to your CD, check that the bank issuing the CD is a participating FDIC institution and that you are within the applicable FDIC insurance protection limits.

Term

The term is the length of time for which you are committing your deposit. This can be as short as one month, or it can stretch over multiple years.

Interest rate

This is the percentage of your deposit that will be added to the value of your CD. Two things that will generally raise CD rates are the length of the term and the size of your deposit. Rates vary from bank to bank, so it pays to shop around for the best rates.

Early redemption penalty

In return for guaranteeing you a specified interest rate over the term of the CD, the bank will generally require that you leave your deposit in the CD for the length of that term. If you have to withdraw your funds early, you may be subject to an early redemption penalty.

Call feature

Some CDs have call features which allow the bank to terminate the CD early. This can negate the benefit of locking in a rate of interest, so be sure to check on any call features before you sign up.

Don’t Get Too Complicated

Most CDs are fairly simple; however, like many financial instruments they have had some twists and turns applied to them over the years. For example, there are brokered CDs that pool depositors into a CD, or equity-linked CDs that incorporate some component of stock market growth into the CDs return. While these variations on the basic CD may offer enhanced return opportunities, they can also carry additional risks. Unless you thoroughly understand the provisions of these more complex CDs, the best advice is to stick to simple and straightforward CDs.

Richard Barrington

Richard Barrington, CFA, is a 20-year veteran of the financial industry, including having served for over a dozen years as a member of the Executive Committee of Manning & Napier Advisors, Inc.

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