Boring. That is how one should think of certificates of deposit, or CDs.
While they may barely keep up with inflation and should not be the keystone of a longer-term investment plan, they are well suited for a specific purpose: maintaining their value and paying a modest but predictable return for a specific period of time when you can’t afford the risk of loss.
A standard bank CD is a contract: You deposit your money for a set period, and in return the bank pays a fixed interest rate until the end of the contract, when you get your original deposit back. That certitude makes them a useful tool in planning for future expenses with a known timeline. Think next semester’s college tuition payment, or saving up for a down payment on a new home next June.
Matching the maturity of a CD with the timing of the expense can provide a degree of certainty while earning a competitive short-term, low risk return that is insured by the federal government, subject to specific conditions.
The concept of depository accounts is nearly as old as civilization itself. In ancient Mesopotamia around 2000 BCE, temples were considered secure, trusted institutions where merchants and farmers could store valuable commodities like grain and silver. Wherever banking appears, regulation cannot be far behind: the Code of Hammurabi (c. 1754 BCE) set rules regarding goods left for safekeeping as well as guidelines for allowable interest rates on loans.
Under the 15th century Medici dynasty in Italy, demand deposits that earned interest became commonplace. Quasi-public banks soon developed in Spain, the Netherlands and ultimately in London with the establishment of the Bank of England in 1694.
In the fledgling United States, mutual savings banks in the early 19th century took in small interest-bearing deposits and made modest loans.
The National Bank Act of 1863 created federally chartered banks and established a regulatory framework for “time deposits,” the precursor of the modern certificate of deposit or CD. The concept caught on.
According to the Federal Depository Insurance Corporation (FDIC), Americans hold nearly $3 trillion in bank certificates of deposit today.
How bank CDs work
When you open a CD at a bank or credit union, you deposit a lump sum for a fixed term, commonly ranging from three months to five years.
Interest accrues at a stated rate and is typically quoted as an annual percentage yield, or APY, to account for compounding if the interest pays at maturity. Many banks also offer periodic interest payouts that do not compound but distribute the earnings each month or quarter.
Aside from length to maturity, bank-issued CDs often include restrictions that limit your ability to withdraw your funds early. These early withdrawal penalties usually comprise a portion of the interest earned, typically 90 days’ worth of interest on a 1-year CD. However, note that withdrawing very early from the contract may result in a loss of principal if you have not yet earned enough to cover the penalty.
Some CDs allow penalty-free withdrawals after a brief initial period, typically 7 days. In exchange for their flexibility, rates on no-penalty deposits sport a lower yield. And it pays to shop around: online banks, with lower overhead, often pay more than large branch-based institutions.
A useful strategy is the CD ladder: dividing your money among CDs maturing at staggered intervals, say three months, six months and one year to plan for known expenses. As each rung of the ladder matures, you can spend the cash or reinvest it in a new instrument.
The safety of bank CDs rests on federal deposit insurance. The FDIC covers deposits up to $250,000 per depositor, per insured bank in the event of a collapse of the institution. Credit union deposits get equivalent protection through the National Credit Union Administration.
An individual with accounts at one bank is protected up to $250,000 across their individual accounts, but separate coverage can apply to joint accounts, retirement accounts and certain trusts. Just be sure to confirm that the bank is truly FDIC-insured before buying.
Brokered CDs: a different animal
While most people are familiar with bank CDs, so-called brokered CDs look similar but can offer additional benefits not typically available with the traditional variety.
Rather than attract relatively small deposits from its own customers, banks sometimes wish to raise large amounts of capital all at once. They can do this by creating one very large certificate of deposit (in the millions of dollars) and selling it to a brokerage firm. The broker then divides up this “master CD” into $1,000 increments available for sale to its individual clients.
Unlike a bank CD, these brokered versions can also be traded in the secondary market, much like stocks and bonds. The market price is a function of prevailing interest rates, so returns may include gains or losses on the difference between their face value at maturity and the price they paid, again much like a bond.
Brokerages let you compare hundreds of FDIC-insured offerings from banks nationwide, and rates can be higher than what you may find locally. You can easily spread money across many issuers to maximize FDIC insurance. And rather than paying an early withdrawal penalty, you can sell a brokered CD on the secondary market before it matures. Interest is generally paid periodically rather than compounding, providing cash flow to the owner.
Additionally, many brokered CDs include a call provision allowing the issuer to redeem the certificates at face value if they choose. Some also offer a survivor’s option or “death put” that allows the estate of a deceased holder to redeem at full value with interest even if the market value has declined.
Choose a bank CD when simplicity and certainty matter. Consider brokered CDs if you already use a brokerage, want wider selection or a bond-like secondary market, and are comfortable with price risk if you sell early but appreciate the extra features.
A CD will never get your heart racing, but that is precisely the point.
Christopher A. Hopkins, CFA, is a co-founder of Apogee Wealth Partners in Chattanooga.