What Is a Certificate of Deposit?

For the past year, the Federal Reserve has been increasing national interest rates, which has resulted in the interest rates for certain types of investments increasing as well. Along with treasury bonds and corporate bonds, another highly sought-after investment opportunity involves certificates of deposit. With the right approach, investing in certificates of deposit can help you obtain consistent returns in an otherwise volatile market. In this guide, you’ll learn everything you need to know about CDs and how to use them.

What Is a Certificate of Deposit?

A certificate of deposit is a kind of savings account that comes with a fixed interest rate. The main difference between a standard savings account and a certificate of deposit is that the latter has higher interest rates. CDs also have fixed term lengths as well as a set date of withdrawal, which is referred to as the date of maturity.

Your can lock your funds in one of these accounts for a period of time that ranges from around three months to as long as five years. You’ll discover that CDs don’t charge monthly fees. On the other hand, the majority of these accounts are outfitted with an early withdrawal penalty.

These accounts are fully insured, which means that you’ll still have access to your money in the event that your bank ever goes bankrupt. If you’re looking to invest in CDs at credit unions, they are referred to as share certificates, which are insured directly by the National Credit Union Administration.

How Does a Certificate of Deposit Work?

If you want to open one of these accounts, the process for doing so is just like the one for opening a standard bank account. You can usually apply in person or online with your financial institution of choice. The first deposit you make into this account will be the sole deposit you make. Contributions can’t be added over time.

Any interest that you earn in a certificate of deposit is typically compounded before being credit to your account. Depending on the exact account, interest could be credited on a daily or monthly basis. Following the conclusion of a CD’s term, the bank usually renews the certificate at an entirely new rate, which will typically match other new CDs.

How are CD Interest Rates Determined?

Before you purchase a certificate of deposit, you should know how interest rates for these accounts are determined. As mentioned previously, the Federal Reserve takes actions during the year that set nationwide interest rates. Banks and other institutional lenders use these actions to dictate their movements in regards to interest rates for everything from certificates of deposit to mortgage loans.

In most cases, the Federal Reserve makes new decisions on whether to reduce, raise, or do nothing to the federal funds rate every 6-8 weeks. Keep in mind that this rate is the interest rate that banks are required to use when borrowing money from the Federal Reserve. At times when the federal funds rate is relatively low, banks don’t have as much incentive to focus on deposits from consumers. When this rate is high, banks will offer more competitive rates for their deposits.

Back in the beginning months of 2020, the federal funds rate dropped to around 0%-0.25%, which was meant to help stimulate economic growth because of the COVID-19 pandemic. When these rates were at their lowest, CDs weren’t an appealing option to most investors. However, 2022 has seen sizable increases in interest rates, which is highly beneficial for investors who want to gain a good return when placing money into a certificate of deposit.

It’s expected that the Federal Reserve will continue making increases to the federal funds rate, which means that certificate of deposit rates should increase as well. The average CD rate is currently between 3.25%-3.47%. However, it’s possible to obtain interest rates as high as 4%.

Certificates are largely considered to be safe investments regardless of the level of risk you want your investment portfolio to be at. Now that interest rates are on the rise, investing in CDs gives you the opportunity to accrue high returns. Make sure that you compare rates before making an investment.