5 Things to Know Before Opening a CD

posted on 08-13-2019

Want to keep your emergency fund safe while earning interest yields that are three to five times higher than a typical savings account? Putting your money into an FDIC-insured Certificate of Deposit (CD) account is definitely worth considering.

But only so long as you know what you're getting into, and how to choose the right CD for you.

In my past experience as a teller and personal banker, I saw how many customers would hastily jump into CDs with the highest interest rates only to find themselves paying the bank hundreds of dollars in completely avoidable penalty fees. I also witnessed other customers who shied away from pocketing much more interest income every month because they were much more risk averse than they needed to be.

So how do you know what kind of CD is right for you? And how can you maximize your interest income while minimizing the risk of paying penalties? By reading the five things you need to know before opening a CD:

1. What is a CD? How do CDs Work?

CDs are a type of long-term deposit account that you can open at a bank, credit union, or brokerage firm. When you open a CD with a financial institution, you are agreeing to keep that money with them for a fixed term of your choosing -- usually from six months to five years. In exchange, the financial institution will pay you regular interest payments (usually quarterly or semiannually) based on your account balance, until the CD matures.

Because you're expected to keep your money in a financial institution's CD for a certain amount of time, these accounts typically pay higher interest rates than savings accounts, which are more liquid (accessible for withdrawals at almost any time).

In general, the longer the term of the CD you choose, the higher the interest yield you'll earn. For example, a bank may offer you a 1% annual percentage yield (APY) on a 6-month CD, but may also offer a much more enticing 2.5% APY on a 5-year CD.

2. Are CDs FDIC Insured?

CDs offered through member-FDIC banks are insured by the FDIC (Federal Deposit Insurance Corp) up to $250,000 per person, per financial institution. That means if a member-FDIC bank goes bankrupt or can otherwise not repay its deposit holders, the FDIC will guarantee that you will be repaid your balance up to $250,000 per account holder. The FDIC can help you find member-FDIC banks through the FDIC BankFind tool.

What does "per account holder" mean? That means if you and your siblings are all co-signers on a CD, then you're each insured up to $250,000. If you and your three siblings share the CD account, the account would be covered by the FDIC for $1 million ($250,000 x 4 account holders).

3. Can You Add Money to a CD?

To start, most CDs can be opened with an initial deposit of $1,000, though some banks, credit unions, and brokers may require smaller opening deposit amounts. If you're lucky enough to have $100,000 or more to deposit at the start, you may open a "Jumbo" CD, which can offer higher interest yields than a regular CD.

From there, many financial institutions allow you to make additional deposits into the CD at any time. The more money you add, the larger your principal balance will grow, and the more interest you'll earn over time.

4. How Do I Choose the Right CD Term for My Savings?

This is a great question especially if you're deciding where to keep your emergency fund.

First, ask yourself two questions before you decide what term-length CD you should take out: 1) How soon do I need access to this money (if ever), and 2) Do I think interest rates will stay flat, rise, or go down over the next few years?

If you believe interest rates will rise more than one percentage point within the next few years, consider putting your money in a short-term CD (i.e. six-month, one-year, or two-year CD). That way if interest rates rise, you can simply wait until your short-term CD matures, cash it out, and then move it to a higher paying, short-term CD. Short-term CDs may pay lower interest rates, but the added flexibility may come in handy in an uncertain or rising interest rate environment.

If you don't believe you'll need access to your money for a while and you believe interest rates will stay flat or barely rise over the next few years, you'll probably be happy to pocket the high yields offered through a five-year CD. Just remember that with high-yields comes low flexibility: For example, if you're locked into a five-year CD and interest rates rise significantly within the next five years, you could miss out on opportunities to invest in new CDs with much more attractive interest yields that pop up in the future.

In any event, you do have options to close a CD early and withdraw your money in case of emergency or if better opportunities arise. Which brings us to our last question:

5. Can I Withdraw From My CD Early?

Yes. But while you may take the money out of your CD early, you will likely face consequences from the financial institution. The penalty for an early withdrawal can mean forfeiture of the interest you’ve earned or even some of your principal depending on your CD's term and the bank.

The longer the term of the CD, the more earned interest you may have to forfeit if you break the term agreement early. Penalties can range from as little as seven days simple interest (if you withdraw six days after you open the account), to six months' worth of interest.

That said, some banks may not penalize for full withdrawals (Ally Bank comes to mind), and some banks allow you to withdraw the amount of interest you've earned without penalty.

The takeaway? If you want to maximize your interest income and minimize the potential bite of penalty fees, be realistic about how soon you may need access to your money and choose the right CD term accordingly.

If you're thinking of using a CD as an emergency fund, you may also consider opening a high-yield savings account that can be accessed more easily so you won't risk getting hit with a CD's early-withdrawal penalty. You can learn about more options for your savings in the articles listed below. Best of luck!

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