Basics of a Certificate of Deposit

Financial institutions started offering CD’s in the mid-1900’s to quickly raise more capital, to then lend out at a higher interest rate. CD’s are simply saving accounts, but with an interest rate that’s guaranteed until a predetermined expiration date. However, there’s usually a penalty to access funds within the CD prior that expiration date. CD’s will typically offer a higher interest rate than a basic savings account because of this penalty accessing funds.

Benefits of a Certificate of Deposit

Most banks, credit unions, brokerages, and other financial institutions will offer a certificate of deposit as one of their saving products, as a way to continually raise capital by offering a higher interest rate than a basic savings account. As a consumer, that’s the biggest benefit of opening a certificate of deposit account: a higher interest rate. It also allows you to mitigate surprises with deposit account interest rates. For example: If you believe savings interest rates will go down over the next 1-3 years, you might consider a 12-36 month CD that will lock your interest rate for the length you choose. 

Important – CD rates will differ from each institution based on a few key factors. Rates will be higher at institutions that are looking to raise more capital quickly. Rates will be lower at institutions looking to slow the amount of deposits coming in. Other common reasons rates will differ are term lengths, CD type being offered, and overall economy. See below for more on each.

Factors That Affect CD Rates

CD rates are influenced directly and indirectly by just a few factors:

Length of CD Term – A shorter length of CD term will offer a lower interest rate than a longer length of CD term. For example: A 90-day CD could offer 0.50% APY, whereas a 3-year CD could offer 2.00% APY.
*APY = Annual Percentage Yield: The actual annual rate of return on an investment, taking into account the interest rate compounded over the course of 12 months.

Type of CD – There are three types of CD’s commonly offered: Fixed-rate, bump-up rate, and variable-rate. A fixed-rate CD will offer an interest rate that will not change until the CD expires or matures. A bump-up rate CD will offer an interest rate that will progressively increase over time until the CD expires or matures. A variable-rate CD will offer an interest rate that will change based on the institutions current CD rates.

Balance of CD – Most institutions will offer a higher rate based on either how much you’re depositing within the CD, or based on your relationship at that institution. For example: Depositing $1,000 into a 12 month CD will earn 0.50% APY, however depositing $100,000 into a 12 month CD will earn 1.25% APY.

Financial Institution – Rates will higher at institutions that are looking to raise more capital quickly. Rates will be lower at institutions looking to slow the amount of deposits coming in. Institutions will also compare locally against other competitors.

Economy – In general, as lending rates rise, deposit rates could rise. In general, as inflation rises, deposit rates could rise. There are other economic factors that influence those two statements.

Our Take.. Good or Bad?

We do not recommend CD’s.

As an investment, CD’s have historically only outperformed basic saving accounts. CD’s were initially offered as a way for banks to quickly raise more capital, to then lend out at a higher interest rate. They were never thought to be a recommended tool for consumers in their financial planning. Some consumers continue to gravitate towards CD’s, as an investment offering a higher interest rate than a basic savings account, but it’s unlikely high enough to compete with other investment options.

We do, however, believe an argument can be made for CD’s being a temporary tool to help consumers learn how to budget their finances appropriately. Many consumers who find it difficult to budget between just a checking account, could find value with using a CD to move money out-of-sight from that checking account into a CD. Using this theory, we recommend looking at CD’s with lengths 6 months or less, to help teach you how to save for an emergency fund or other short-term financial goals.