How CD Accounts Work

Money growing over time with CDs

How CD accounts work is essentially as a time deposit.

In exchange for depositing funds for a specified length of time at a bank, consumers receive a rate of interest usually higher than available in savings and money market accounts. But, unlike their savings and money market accounts, the CD (certificate of deposit) is not liquid. The bank has total access to that money, which is locked in for a certain length of time to lend out. In most banks, the principal and interest are protected by the Federal Deposit Insurance Company (FDIC) or the institution’s private insurance. If it is not, then the interest rate will be higher.

That length of time for the CD lock-in can range from a month to several months or years. There are substantial penalties for early withdrawal. For instance, for a five-year CD, the depositor could lose six months’ interest. Therefore, the best practice is to only agree to lock in the funds for the period when it is unlikely the money will be needed. Also, this kind of stiff penalty deters depositors from opting out of the CD account to place the money in what seems at the time to be a more lucrative form of investment.

The rate of interest may be fixed. Often the larger the amount of principal and the longer the period, the higher the interest rate will be. CDs purchased by individuals usually provide higher interest than those by businesses.

The rate of interest can also be variable. One type of variable option is the bump-up. During a period when interest rates are expected to fluctuate, depositors can choose for one modification. In addition, the rate might be indexed to the bond or stock market or other indices, such as venture capital or commodity.

Some depositors leverage what is known as the Ladder Strategy. They divide up their total funds into a number of different amounts for a number of different maturity dates. Therefore, when interest rates are low, they spread the risk of rising interest rates by not completely locking themselves in at the current level. When interest rates are high, they protect themselves against possible declining rates by locking in the current high rates for, say, five years.

Near the date of maturity, the bank notifies depositors of their options. They can “roll over” the CD for the same length of time, such as six months or five years. The interest rate offered by the bank might be higher or lower than the original one. Or depositors can purchase a different kind of CD, transfer the money to a checking or savings account, or withdraw the funds.

CDs can be purchased online, by phone, and in person.

Now that you know how CD accounts work, consider an investment of a certificate of deposit at Bank5 Connect.

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