Finance

CD Investments: How Much You Can Earn | How Does A CD Work

August 15, 2022

Do you want to know all about this “CD Investments: How Much You Can Earn”? Then you are simply welcome here. There are reviews about this same topic but it seems that the reviews don’t really clarify what the topic entails.

On this page, you are going to understand what this really entails the information isn’t that long but they are very important. So if you are interested in knowing about this you should then keep on reading.

CD Investments: How Much You Can Earn

A certificate of deposit (CD) is simply a savings product that simply earns interest on a lump sum for a fixed period of time. The CDs differ from savings accounts because the money must remain untouched for the entirety of their term or risk penalty fees or lost interest. CDs usually do have higher interest rates than savings accounts as an incentive for lost liquidity.

Why Would I Open a CD?

Unlike most other investments, CDs offer fixed, safe—and also generally federally insured—interest rates that can even often be higher than the rates paid by many bank accounts. And the CD rates are generally higher if you are then willing to sock your money away for longer periods.

CDs have become a more attractive option for savers who simply want to get or receive more than most savings, checking, or money market accounts pay, but without taking on the risk or volatility of the market.

How Does A Certificate Of Deposit (CD) Work?

A certificate of deposit (CD) is a simple and popular savings vehicle that is been offered by banks and also credit unions. When a depositor then purchases a CD, they will also agree to leave a certain amount of money on deposit at the bank for a certain period of time, such as one year.

In exchange, the bank will also then agrees to pay them a predetermined interest rate and even guarantees the repayment of their principal at the end of the term. For example, investing $1,000 in a one-year, 5% certificate would simply mean you will be receiving $50 in interest over the course of one year, plus the $1,000 you initially invested.

CDs vs. a Savings or Money Market Account

CDs are a special type of savings instrument. Like a savings or money market account, they help to provide a way to put money away for a specific savings goal—such as the down payment on a house, a new vehicle, or a big trip—or to park funds that you simply do not need for day-to-day expenses, all while making a certain return on your balance.

But whereas savings and the money market accounts can let you to vary your balance by making additional deposits, as well as up to six withdrawals per month, CDs also then require one initial deposit that stays in the account until it then reaches its maturity date, whether that’s six months or five years later. In return for giving up access to your funds, CDs also generally pay higher interest rates than savings or money market accounts.

How Are CD Rates Determined?

Anyone who has been following interest rates or business news, in general, knows that the Federal Reserve Board’s rate-setting actions loom large in terms of what the savers can get on their deposits.

That is because the Fed’s decisions can simply directly affect a bank’s costs. Here is how it works.

Every six to eight weeks, the Fed’s Federal Open Market Committee (FOMC) decides whether to raise, lower, or leave alone the federal funds rate. This rate will then represent the interest that banks pay to borrow money through the Fed.

When the Fed money is cheap (i.e., the federal funds rate is low), then the banks have less incentive to court deposits from consumers. But when the federal funds rate is then moderate or high, banks can do even better by paying consumers a competitive rate for their deposits.

In the year December 2008, the Fed reduced its rate to the lowest level possible of essentially zero as a stimulus to simply help lift the U.S. economy out of the Great Recession. Even worse for savers was that it left rates anchored there for a full 7 years. During that time, the deposit rates of all kinds—savings, money market, and CDs—tanked.

Are CDs Safe?

CDs are also one of the safest savings or investment instruments that is available for two reasons:

First, their rate has been fixed and also guaranteed, so there is no risk that your CD’s return will simply be then reduced or fluctuate. What you signed up for is what you will simply get—it’s in your deposit agreement with the bank or credit union.
Second, the CD investments are also even protected by the same federal insurance that covers all deposit products. The Federal Deposit Insurance Corp. (FDIC) offers insurance for banks, and also the National Credit Union Administration (NCUA) offers insurance for credit unions. When you then open a CD with an FDIC- or NCUA-insured institution, up to an amount of $250,000 of your funds on deposit with that institution are simply then protected by the U.S. government if that institution were to fail. Bank failures are also exceptionally rare these days, but it is very good to know that a bank failure would not put your funds in jeopardy.

The key to ensuring that your funds are as safe as possible is to ensure that you choose an institution that simply carries FDIC or NCUA insurance (the vast majority do, but a small minority carry private insurance instead), and also to avoid exceeding the amount of about $250,000 in deposits in your name at any one institution.

If you are then holding more than that amount in deposits, you can even maximize your coverage by spreading your funds across multiple institutions and/or more than one name (e.g., your spouse).

When Is Opening a CD a Good Idea?

The CDs are very useful in a few different situations. Typically, you have cash that you do not need now but will want them within the next few years—maybe for a special vacation or to buy a new home, car, or boat. For near-term uses like that, the stock market generally is not then considered a suitable investment, as you can simply lose money over that period of time.

Or maybe you simply want some portion of your savings that has been invested very conservatively, or you shun the risk and also the volatility of the stock and bond markets altogether. Though CDs do not offer the growth potential of equity or debt investments, they also do not carry a risk of downturns. For cash that you want to absolutely ensure will grow in value, even if modestly, CDs can then fit the bill.

One of the downsides of the CDs can also be of a useful feature for some savers. For those who then worry that they will not have the discipline to avoid tapping into their savings, the fixed term of a CD—and the associated penalty for early withdrawal— will then provide a deterrent to spending that regular savings and money market accounts do not.

Pros

Offers a higher rate than you can earn with a savings or money market account.
Pays a guaranteed, predictable rate of return, avoiding the volatility and losses that are possible with stocks and bonds.
Is federally insured if opened with an FDIC bank or NCUA credit union.
Can help fend off spending temptations since withdrawing the funds early triggers a penalty.

Cons

Cannot be liquidated before maturity without incurring an early withdrawal penalty.
Typically earns less than stocks and bonds can over time.
Earns a fixed rate of return regardless of whether interest rates rise during the term.

How Much Do I Need to Open a CD?

You should know that each bank and credit union establishes a minimum deposit that is been required to open each CD on its menu. Sometimes the bank will then set a minimum deposit policy across all CD terms it offers, while some will even instead offer rate tiers, providing a higher annual percentage yield (APY) to those who meet higher minimum deposits.

In theory, when having more funds available to deposit will then get you a higher return. But in practice, this does not always hold true. For example, having about $25,000 ready for deposit will occasionally help you to open a CD that is not available to others with lesser amounts. But lots of the top 10 rates in each CD term can even be achieved with modest investments of just about $500 or $1,000. And the vast majority of top rates are also available to anyone with at least about $10,000. A $25,000 deposit is only occasionally required for a top rate.

How Do You Find The Best CD Rates?

Shopping for the best CD rate can then take a lot of research but Investopedia has simply done the hard work for you and also even maintains lists of the best rates available no matter what length of time you are looking for:

How Are CD Earnings Taxed?

When you hold the CD, the bank will then apply interest to your account at regular intervals. This is simply done either monthly or quarterly and will then show up on your statements as earned interest. Just like the interest paid on a savings or money market account, it will also then accumulate and be reported to you in the New Year as interest earned, so that you can then report it as income when you file your tax return.

Sometimes users or people get confused about this because they are not able to withdraw and even use those interest earnings. Their expectation is very simple and it is that they will be taxed on the earnings when they withdraw the CD funds at maturity (or sooner if they cash out early). This is incorrect. For tax-reporting purposes, your CD earnings are simply taxed when the bank simply applies them to your account, regardless of when you withdraw your CD funds.

Is A CD An Investment?

Yes, a CD can be then considered as an investment — or simply a means of generating returns — for your short-term savings. Investment does not refer to only funds in the stock market.

Are CDs A Good Investment?

Yes, if you are then looking for guaranteed returns with little to no risk. Other types of investments, such as the stock market, can then be able to offer greater returns, but with much greater risk.

How Much Interest Will I Earn In A CD?

It also depends on the interest rate the bank offers and also the length of the CD’s term. Here is an example: the amount of $5,000 invested in a 1-year CD with a 2.00% APY would then earn about $100 by the end of the term.

Can You Lose Money In A CD?

Yes, you can simply be able to lose money on CD, but only if you then withdraw your money from a CD before the term ends. Most banks can even charge a penalty fee equal to a certain amount of interest, for instance, six months’ worth.

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