Explained: Certificates of Deposit

What they are A certificate of deposit (CD) is a short term savings investment that is tied to a specific interest rate of return for a determined amount of time. For example, a CD can usually be purchased in 6 month increments up to 5 years with the interest rate set for the entire period of time.

How they work

When you invest in a CD you agree to a specific interest rate and then over the predetermined time frame your investment will grow in value. When the CD vests at the end of the time duration that was selected, it can either be withdrawn into a different account or reinvested into another certificate automatically. If the money is withdrawn before the end of the term, there is a penalty (usually close to 3 months of interest).

What they are used for

An example of why someone would invest in a certificate of deposit would be if they had a mid-range savings goal. If you were going to be making a large purchase in the next few months the money should just sit in a high interest savings account. If you are saving for longer than five years away, like for retirement, your investments can have more risk and opportunity for growth attached to index funds. CD’s are low risk investments that are great for saving money for the future.

How to set one up

Contact your bank or look on their website to see what their current CD interest rates are. I use ING Direct for my primary bank account and also to invest my certificates of deposit. ING Direct’s current rates can be found here. (If you would like to sign up for an ING Direct account please contact me and I can give you a $25 referral bonus). Most banks allow you to easily pick the duration of a CD online and you can often see it alongside of your other checking and savings accounts on their website.

How to make a CD ladder

One way to use certificates of deposits but still keep liquidity of the money is by creating a CD ladder. A perfect use of a ladder would be for an emergency fund that is broken into six equal amounts. You first invest 1/6 of the total amount in a six-month CD. The next month later you invest another 1/6. You do this until all six parts are invested and set all of the CD’s to reinvest when they vest. This way, if you do need one month of living expenses it will become available one month at a time. The money will also be receiving a better interest rate than if the money was just sitting in a checking or savings account.

Have you ever used a CD before or have any questions before starting one? Leave a comment below.