What is a CD and When is it Right for You?

Estimated read time: 5 minutes

You have a lot of choices when it comes to where to park your money. The two most common and well known are checking and savings accounts, but those accounts aren't always the best place to store money for a variety of reasons.

You need another option. A CD might be the perfect solution. A CD is similar to a savings account but has some distinct and important advantages that a savings account lacks.

What is a CD?

First thing's first. CD stands for Certificate of Deposit. A CD is a type of savings account with a set interest rate and a set date of withdrawal called the maturity date. The term of the CD can be from a few days to ten years, but the standard term is from three months to five years. The longer the term, the higher the interest rate you'll get on the CD.

The bank is willing to pay more interest on a CD than a checking or savings account because they can use your money to make long-term loans knowing you won't withdraw that money (well, you can, but you'll be penalized, which is deterrent enough for most people) until the maturity date.

Different banks and credit unions have different interest rates, and it's in your best interest to shop around for the highest one. Rates on CDs vary, but you can expect to see rates in the high 2% to low 3% range. Online banks often have higher interest rates than do brick and mortar banks as they don't have as much overhead. All that street-level real estate taken up by banks isn't cheap!

CDs are one of the safest ways to invest your money. They are FDIC insured when purchased from a bank and NCUA insured when purchased from a credit union.

A CD is a type of savings account with a set interest rate and a set date of withdrawal called the maturity date.

Benefits of a CD

You put your money in a checking account because it's a safe and convenient place from which to pay your bills. You put your money into a savings account so it's slightly less accessible than the money in your checking account and to earn a little more interest than your money will earn in a checking account.

So why would you need a CD if you already have a checking and savings account? CDs typically pay a higher interest rate than do savings accounts. You're not going to get rich from a 3% interest rate, but it's something.

A CD is also a good way to keep your money from burning a hole in your pocket. Yes, the money in a savings account is a little harder to get to than the money in your checking account, but you can transfer it to your checking account with a few clicks of the mouse. It will be instantly available to buy whatever your heart desires. When your money is in a CD, you can get to it, but you'll pay a penalty for doing so.

Investing in stocks is one of the best ways to grow your money, but it isn't without its risks. Some years your investment might make 10%, and some years it might lose 3%. There is none of the up and down of the stock market when you invest in CDs. The rate you bought it at is the rate it will pay.

When Should You Use a CD?

There is a rule of thumb when it comes to investing in the stock market that says you shouldn't invest money that you'll need in the short term, within five to ten years. That isn't enough time for your investment to ride the ups and downs of the stock market. If you needed it in five years and when the time came we were in a bear market, it would be a terrible time to sell off your investments.

But you don't want money sitting in a checking or savings account for that long making almost no interest at all. Especially if it's a rather large sum of money that you're saving for something like a down payment on a home or to do some major home renovations.

A CD can be the perfect middle ground between making almost no interest but still being a safe short-term place to invest your money.

CD Ladders

Still hate the idea of having your money locked away from you? You can use a strategy known as a CD ladder. A CD ladder means buying multiple CDs that mature at different times. This allows you to take advantage of rate increases while being able to access your money without penalty.

An example is to divide money across five CDs with one maturing each year. Let's use $5,000 as an example:

  • $1,000 in a one-year CD
  • $1,000 in a two-year CD
  • $1,000 in a three-year CD
  • $1,000 in a four-year CD
  • $1,000 in a five-year CD

When the first CD matures, you can move that money over to a five year CD. At the end of year two, you move that money into a five year CD. And so on and so on. You continue to increase your interest rate while still having access to your money because you can take part or all of it and transfer it to your checking account if you need the cash.

The Right Accounts for the Job

It's ideal to keep six to eight weeks worth of your regular expenses in your checking account. This is your "everyday" money, and a checking account has money coming in and going out of it frequently.

Your emergency fund, ideally containing three to six months worth of expenses, should be kept in your savings account. While it stings to have that much cash sitting in a low-yield account, your emergency fund needs to be in a liquid account so you can access it quickly.

Money you're saving for retirement should be in taxed advantaged retirement accounts like 401ks and IRAs.

Money being saved for short term goals, those things you plan to do within five to ten years, is the kind of money you want to invest in CDs. CDs are low risk while providing higher interest rates than a savings account does. They also provide a barrier to spending money you should be saving due to the penalty for early withdraw.

If you're not sure when you'll need to access this money, you can use the CD ladder strategy to give yourself some flexibility while still benefiting from the higher rate of interest that CDs offer.

A Valuabe Tool

CDs are a financial product that offers real value. They strike just the right balance between gaining a return on your money while being a safe place to invest that money. With a variety of terms, you can choose the perfect CD for you.