As you build a solid financial foundation, you’ll encounter countless ways to safeguard and grow your money. Some options are better than others, and a certificate of deposit is a worthwhile option to grow your savings. So, what is a certificate of deposit? And what are the advantages and disadvantages of a certificate of deposit?
Let’s explore this opportunity so that you can decide for yourself if this is a good choice for your financial plans.
What is a certificate of deposit?
First things first, what is a certificate of deposit? Essentially, a certificate of deposit, otherwise known as a CD, represents an agreement between you and a financial institution.
When you place your funds in a certificate of deposit, you agree to leave the funds there for a specific period of time. In exchange, the financial institution agrees to reward you for this choice with an agreed-upon APY (annual percentage yield).
At the end of the CD term, you’ll receive access to your funds again. Additionally, you’ll enjoy the benefits of the APY, which means you receive your funds plus extra funds as a return on this investment.
How does a certificate of deposit work
Now you know what a CD is, but you may be wondering, "how does a certificate of deposit work?" So, let’s take a closer look at the nuts and bolts of how a CD actually works. When you choose to place your savings in a CD, you agree to leave the funds untouched for a specified period of time. Depending on the CD, the term could be just a few months or several years.
Importantly, you will not have access to the funds you place in a CD for the duration of the term. In some cases, you may be able to pull out the funds early. However, you’ll likely have to pay a penalty for that decision.
The financial institution will have access to the funds for the duration of your CD’s term. At the end of the CD term, you will regain access to your funds. The financial institution will reward you with a predetermined APY in return for this access to your funds. These additional funds will also be available for you when the CD matures.
Leverage a certificate of deposit calculator
So how much can you earn by placing your funds in a CD? The amount will vary dramatically based on the APY available. Take some time to play around with a certificate of deposit calculator to see how much you can earn.
Two easy calculators to use include Bankrate's certificate of deposit calculator and CIT Bank's certificate of deposit calculator.
Advantages and disadvantages of a certificate of deposit
Every financial product comes with pros and cons. Here are the certificate of deposit advantages and disadvantages that you should be aware of:
Advantages of a certificate of deposit
Let’s start with the advantages. CDs offer a sense of security. When you place your funds into a federally insured CD, you know that you’ll have access to your funds at the end of the term. Plus, you’ll enjoy a set rate of return on your investment.
The predictability that comes along with placing funds in a certificate of deposit can’t be overlooked. You can use the stability offered by this type of investment to stabilize your personal finances.
Since CDs come in all sizes and terms, you can likely find a CD that fits your particular needs. For example, you could use a CD to help save for a major future purchase by tucking the money away for safekeeping. You won’t have access to the funds throughout the term. But with the right planning, you could tap into the funds exactly when you need them.
Disadvantages of a certificate of deposit
Of course, there are also some disadvantages to be aware of. While CDs are considered somewhat liquid assets since you can access them easily, there is a catch. In most cases, you cannot access the funds within a CD without paying a penalty. That’s a big issue for some investors.
It is also worth noting that you can likely find a higher rate of return with another type of investment. Although CDs offer predictable returns, the low risk comes with relatively low interest rates.
Should you open a certificate of deposit?
So now you know about the certificate of deposit advantages and disadvantages. But should you open a certificate of deposit? Although a CD is a worthwhile financial tool, it’s not the right move for everyone. As with all financial decisions, the move to open a CD will depend on your personal financial goals and risk tolerance.
A CD is probably not the right move if you have a higher risk tolerance. With a higher risk tolerance, you may want to seek out an investment that offers the potential for higher returns.
But if you have a low-risk tolerance, then a CD could be the right move. You’ll have regular returns and access to your funds on an expected schedule. With that, a CD could be the right way for you to save for major expenses.
Not sure where you stand? Take a look at our risk tolerance quiz to determine your comfort level.
Can a CD help you save for a big purchase?
Since a CD requires you to lock up your funds for an extended period of time, it might not seem like the right move for a purchase. But if you know how long you’ll be holding off on a big purchase, then a CD could be the perfect move. You can tuck away some of the funds you want to use for this major purchase ahead of time.
With some planning, you can align the timing of the CD’s maturity date with your purchase. For example, let’s say that you want to buy a house in 5 years. You have some money saved for that purchase now. Instead of keeping the funds accessible and spendable, you could place it into a CD with a maturity date of 5 years.
By removing the temptation to spend these funds, you’ll have the cash when you need them. Plus, some extra savings based on the APY of the CD.
How to open the right certificate of deposit
The process starts by hunting around for the CD that best suits your needs. You can seek out a CD that has a short-term or very long-term to suit your financial goals.
You can find CD terms as short as one month or as long as ten years. In general, a longer term will come with a higher APY. That's because you’ll have to lock up your funds for a more extended period of time.
Once you choose the CD term that works for you, it’s time to shop around for the right CD. Of course, you’ll want to find a financial institution that provides a competitive rate of return.
But you’ll also want to consider the different types of CDs available. Beyond the traditional CD that we’ve discussed, there are a few other types, including:
No penalty CD
You won’t have to pay a penalty if you decide to pull your funds out before the term. But you’ll likely face lower APYs.
Add-on CD
The financial institution may allow you to add funds at regular intervals throughout your CD term.
Jumbo CD
A jumbo CD will allow you to tuck a significant amount of funds, over $50,000, into a secure investment.
Take the time to find the right CD type for your situation.
Consider a certificate of deposit as part of your portfolio
A certificate of deposit could be the right move for your finances. But you’ll need to be sure about the decision before diving in.
Remember to consider the advantages and disadvantages of a certificate of deposit and take some time to consider your financial goals to see if a CD can fit into the picture. If it does, don't forget to shop around to find the best APY in town.
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