What is a CD (Certificate of Deposit)?

Alright, gather round. This is going to be important.

You’re a checking account expert. You’re a savings account expert. There’s just one more basic financial tool you need to know about: Certificates of Deposit (CDs).

The banks make the arrangement official

Certificates of Deposit (CDs) are kind of like hardcore savings accounts. With CDs, banks make the wishy-washy implied promise of savings accounts to “not take all your money out and run with no warning” and make it concrete with a CD.

So is a CD a physical thing, or just another type of account with the bank?

Fair question. Especially if you’re of a certain age, you might confuse this CD with the kind that stored and played music back in the day. A CD at a bank is just another type of account, but with way more restrictions.

If you remember, a savings account is a weak signal to the bank that you’re planning to leave your money there long-term, but you’re not offering any hard guarantee. So, the bank pays you a bit of interest hoping you’ll keep the money with them longer, but you’re not under any obligation to do so.

With a CD, there is a written guarantee you sign that you won’t take your money back out anytime soon. And banks will hold you to it!

Wait, let me guess. To compensate you for the additional restrictions, CDs pay more in interest?

You got it exactly. If your savings account is only making 1% interest, the CD can make you 5% or more!

So what does this all mean in practice? Well, when you open a CD, you’re agreeing, in writing, to give the bank your money and you’re making a promise, again in writing, that you won’t take any of that money out for a set period of time. This period of time is called the ‘term’ of the CD. In a nutshell, when you put money into a CD, it’s basically gone, 100% inaccessible to you, for the full term in the agreement and the bank pays you interest for your trouble.

When you say I lose access to the money, how long is that usually the case?

It depends on the bank and the type of CD you’re getting into. Some banks offer a wide range of terms from 3 months all the way up to 10 years. Some only offer a few options. In general though, the shorter the term, the shorter the time your bank has guaranteed access to your money, and the lower the interest rate. So, if you want to make more money, you need to let the bank have your money for a longer period of time. If you’re more risk-averse and don’t want to be parted from your money for too long, you’ll pay for that shorter term by being paid less interest on it. So it’s really up to you how long you want to lock up your money in the CD.

CDs are boring, and that’s a good thing

Okay, so let’s say I take the plunge and lock up some money in a CD. What then? Does it just…sit there?

Yup! You just let it sit there. Sound boring? It is! And that’s a good thing. The more locked-up your money is and the longer it is locked up, the more money it will make for you. And that’s what it’s all about!

Even better, if the money is quietly making you money with no drama, you can go on with your life without worrying about it. Compare that to, say, plonking your life savings down on a meme stock or crypto and watching the value fluctuate wildly on a minute-to-minute basis. When it comes to your money making money, boring is good.

Locking your money up in boring CDs:

Earns you a guaranteed interest rate, so there’s no chance you won’t make money. You can only win!
Secures your money in a federally-insured deposit so you can’t lose money, even if the bank goes belly-up.
Removes the temptation to use that money for other purposes. Your savings are truly locked-in and dedicated to making you money, even if you’d rather buy something more fun.

What happens if I need the money NOW?

Okay, worst case scenario time. I need the money out of my CD now and there’s no way around it. If it were a savings account, I could just pull the money, but the CD locks that money away. What do I do?

Right. So you’ve got a CD, your money is happily making money for you, and BAM! a huge racoon flies through the window you left open and tears through your kitchen, wrecking the whole place. Any chance you could get that money you have in the CD back a little bit early…?

Indeed you can! Banks do allow you to cash out your CD early. For a price of course. After all, you DID promise not to touch that money, right? It would only be fair for them to make you pay a bit of a penalty since you’re breaking your promise to them. Typically the penalty will be equal to 2 months worth of interest they paid to you, or all the interest paid to you if the CD is less than 2 months into its term. That’s it though!

Wait though. That means I get all the money back I originally put in right?

Yup! The bank will only “punish” you by taking back some (or all) of the interest they paid you; you can’t lose the money you originally put in!

CDs are kinda like savings accounts in this way. You stand no risk of losing your original deposit and can take your money out if you really need it. So, if you really need the money in that CD back, check to see how much interest you’ve been paid for the last 2 months. If that price is worth it to get your money now, then cash it out, get your money, and do what you gotta do!

Gotcha. Sounds like a good deal to me! How do I know when a CD is right for me?