This is How CDs Work—and How You Can Use Them to Grow Your Savings

If you’re looking for predictable returns at rates that tend to exceed those of savings accounts, then it’s time to find out what CDs are.

The post This is How CDs Work—and How You Can Use Them to Grow Your Savings appeared first on Discover Bank - Banking Topics Blog.

If you’re looking for predictable returns at rates that tend to exceed those of savings accounts, then it’s time to find out what CDs are.

If you’ve got savings goals on your mind, then you know they come in all sizes and time horizons.

As you consider all of your options for hitting those goals—from savings accounts to stocks and bonds to stuffing your cash under the mattress—certificates of deposit stand out among the pack thanks to their competitive rates and safety.

“The reason that people are really drawn to CDs is that you can get a higher return than you would get in either a traditional checking account or traditional savings account,” says Kimberly Palmer, personal finance expert at NerdWallet.

Steady returns, in fact, are among the top benefits of CDs. Plus, Palmer adds that CDs are usually FDIC-insured, typically up to $250,000 for each depositor (or the maximum allowed by law).

What is a certificate of deposit? It's a savings product that provides a guaranteed rate of return over a fixed term.

With all those benefits in mind, you might still be wondering if a CD is the right fit for your savings strategy. So, what is a certificate of deposit and how does it work?

What is a certificate of deposit?

A certificate of deposit provides a guaranteed rate of return (the interest rate) on your money as long as you agree not to withdraw the funds you deposited (the principal) until after a specified amount of time (the term).

“It’s best for someone who doesn’t need their money immediately,” Palmer says. “In exchange for that longer period of time where your money is inaccessible, you earn a higher return.”

How does a certificate of deposit work?

Before you can start using certificates of deposit to keep your savings growing at a fixed rate, it helps to know how CDs work. It’s time to familiarize yourself with this one-of-a-kind savings product.

CD minimum deposit

While you can find savings accounts with no minimum deposit requirement, most banks require a minimum deposit to open a certificate of deposit. As you learn how certificates of deposit work, note that minimum deposits can vary depending on the financial institution, but at Discover it’s $2,500.

CD terms

Once you open a CD, your money grows until it matures at the end of its term. Discover CD terms start at three months, and the longest term available is 10 years.

CD rates

In addition to getting a higher rate than you can on many savings accounts, CD rates are fixed, which means there’s no risk of the rate going down during the term. (Keep in mind they can’t go up, either.) Generally, the longer the CD term, the higher the interest rate you can lock in for your money.

CD early withdrawal penalty

Understanding CD early withdrawal penalties is key to answering the “How does a certificate of deposit work?” question.

You can typically find competitive rates for CDs because your financial institution is counting on having that money for the full term. For that reason, if you pull out any money in your CD before the term ends, you could be hit with a penalty.

Understanding CD early withdrawal penalties is key to answering the “How does a certificate of deposit work?” question.

The early withdrawal penalty often depends on the length of the CD’s term, and it’s a good idea to check with your bank to understand its specific withdrawal penalties.

Got the gist of what a certificate of deposit is? Now it’s time to put this account to work toward your unique savings goals.

How can you use CDs in your own savings strategy?

Because CDs are offered across a wide range of terms, you have the opportunity to get creative with how you take advantage of them. Whether your savings goals are big or small, long- or short-term, there’s a CD savings strategy that will work for you.

Using CDs for short-term goals (less than three years)

“CDs are good for short-term or near-term liquidity needs,” says Philip Gibson, an associate professor of finance.

Let’s say you want to have money ready to spend on an engagement ring a year from now. Putting that money into the stock market could be risky, because if there were a market dip, you’d be out of luck—and you wouldn’t be the only one disappointed!

Instead, Gibson says, you can put that money into a 12-month CD and ensure that it will be there a year from now.

How does a certificate of deposit work out to be a better short-term option than cash, you ask? Money within a CD will have grown thanks to the competitive interest rate. Cash, Gibson points out, typically loses value over time due to inflation.

However, CDs aren’t ideal for storing cash that you might need at a moment’s notice. Remember: If you pull out your money from a CD before the end of its term, you could be on the hook for an early withdrawal penalty. If quick access is a priority, you’d be better off using a checking account or savings account.

Using CDs for medium-term goals (3-5 years)

CDs can be an effective way to save for medium-term goals, but you need to choose your CD term wisely.

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“You want to make sure the CD term you choose matches the time horizon of your goal,” Palmer says.

For example, if you’ll need that money for a down payment on a home in three years, it would make sense to put your money into a CD with a three-year term. A three-year CD would likely give you a higher return than a one- or two-year CD, and your money will be accessible when you are ready to buy a house.

Palmer adds that because money in CDs is only accessible after they mature at the end of their terms, you’ll want to make sure you have three to six months of emergency savings available for unexpected short-term needs before opening a CD with a three- to five-year term.

Using CDs for longer-term goals and retirement

The longer your time horizon for your goals, the more time you have to take advantage of the power of compounding in a CD. Plus, given how certificates of deposit work, longer terms usually have higher interest rates.

If you’re looking even further ahead to retirement, you can open an IRA CD. IRA CDs give you the same reliable growth of regular CDs with the tax advantages of IRAs.

How does a certificate of deposit work when you have multiple savings goals? That's where a CD ladder can be helpful.

Using a CD ladder to support multiple goals

While the above examples show how CDs work to save for specific financial goals, there is a way to use CDs to continually grow your savings as you reach multiple savings goals with varying time horizons. At the same time, with this strategy you can:

  • Keep your funds liquid.
  • Take advantage of interest rates if they go up.
  • Lock in the higher CD rates associated with longer terms.

It’s called a CD ladder, and Palmer says this CD strategy is growing in popularity among savvy savers.

With a CD ladder, you don’t try to guess exactly when you’ll need your funds to be available. Instead, you open multiple CDs with varying maturity dates.

“You might have one CD that matures in six months, one that matures in a year and then another in 18 months,” Palmer says. “That means that the terms keep coming due, and you continually have access to your money.”

What is a certificate of deposit ladder? It's a strategy of opening multiple CDs with varying term lengths to stay flexible.

Every time a new CD matures, you have the option of putting that money toward something you have been saving for, such as a house.

If you aren’t ready to use that money when a CD matures, then you simply open a new CD with a longer term than any CDs you currently have. That new CD is added to the “ladder,” and your money grows at longer-term rates as older CDs approach maturity.

Once you get into a groove with a CD ladder, you can enjoy all the benefits of CDs without worrying about finding a single CD that perfectly matches up with your financial goals.

Ready to get started with a CD?

Now that you have a handle on what a certificate of deposit is and how CDs can work for you, it’s time to get your savings plan started.

Learn how a Discover Certificate of Deposit can help you reach your savings goals, with flexible terms from three months to 10 years.

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Source: discover.com