An In-depth Analysis of Certificates of Deposit (CDs)

Breaking Down Certificate of Deposit (CD)

A Certificate of Deposit, commonly known as a CD, is a financial tool that accumulates interest on a fixed amount over a set period. Unlike a regular savings account, a CD requires the money to be undisturbed for the full term or face penalties or loss of interest. They typically have a higher interest rate compared to savings accounts, making them an attractive option despite the lack of liquidity. CDs are considered a safer and more conservative form of investment compared to stocks or bonds, with guaranteed returns despite the lower growth potential. Banks, credit unions, and brokerage firms all provide a variety of CD options. By shopping around, one can find CD rates that are considerably higher than the industry average for every term.

When someone buys a CD, they commit a specific amount of money for a set duration, for example, a year, to a bank or credit union. In exchange, the institution agrees to pay a predetermined interest rate and guarantees to return the principal at the term's end. For example, an investment of $1,000 in a 1-year, 5% certificate would mean gaining $50 in interest over a year, plus the $1,000 initially invested.

The Fundamentals of Certificates of Deposit (CDs)

Setting up a CD is quite similar to creating a standard bank deposit account. However, the difference lies in what you agree to at the time of signing up. After selecting your CD(s), finalizing the process will involve four elements:

• The interest rate: This is set and provides a predictable return on your deposit over a defined period. Banks cannot alter the rate, which guarantees your earnings. However, a fixed return could be disadvantageous if rates rise significantly during the term of your CD.
• The term: This is the agreed period during which you will keep your funds deposited to evade any penalty. The term concludes on the maturity date, when you can withdraw your funds without penalty.
• The principal: Apart from some specialty CDs, this is the amount you agree to deposit when you open the CD.
• The institution: The bank or credit union where you open your CD will determine certain aspects of the agreement, such as early withdrawal penalties (EWPs) and the reinvestment of your CD if you don't give other instructions at maturity.

Once your CD is set up and funded, it is administered like most other deposit accounts, with regular statement periods and interest payments deposited into your CD balance, where it compounds.

Why Opt for a CD?

CDs offer fixed, safe, and usually federally insured interest rates that can often be higher than many bank accounts. They can be a viable option for savers looking for higher returns than most savings, checking, or money market accounts without exposure to market volatility.

Comparing CDs with Savings or Money Market Accounts

CDs, being a special form of savings instrument, provide a way to save for specific goals like a house down payment, a new car, or a vacation. They can also be used to store funds not needed for daily expenses, ensuring a certain return on your balance.

How CD Rates Are Set?

If you keep a close eye on interest rates or the business news world, you'd know that the Federal Reserve's rate-setting actions significantly impact potential earnings on deposits. The connection between the Fed and a bank's expenses is direct.

The Federal Reserve's Federal Open Market Committee (FOMC) determines whether to elevate, diminish, or maintain the federal funds rate every six to eight weeks. This rate signifies the interest that banks pay to lend and borrow excess reserves to each other overnight via the Fed. The prime rate, the rate banks charge their most credible customers, is influenced by the federal funds rate. Usually, the prime rate is the federal funds rate plus three percentage points. The prime rate then affects the rates for CDs, savings, and loans. A higher prime rate corresponds to more interest you can earn on a CD.

Historically, in December 2008, the Fed slashed its rate to nearly zero to stimulate the US economy out of the Great Recession. This action took a toll on deposit rates across all sectors—savings, money market, and CDs. However, the tide turned in 2022 when the Fed started raising interest rates significantly in response to record-setting inflation. Consequently, between March 2021 and March 2023, average CD rates witnessed a three to four-fold increase.

The individual circumstances of each financial institution also contribute to the amount of interest it offers on particular CDs. For example, if a bank experiences an upsurge in its lending business and requires increasing deposit amounts to finance these loans, it might be more proactive in drawing in deposit customers. Conversely, a large bank with ample deposit reserves might be less inclined to grow its CD portfolio, resulting in less competitive certificate rates.

The Safety of CDs

CDs are among the safest savings or investment options for two reasons:

• First, they offer a fixed and guaranteed rate, eliminating the risk of fluctuating or diminishing returns on your CD. The agreed-upon return at the time of deposit is what you get.
• Second, CD investments are protected by the same federal insurance that covers all deposit products. The Federal Deposit Insurance Corp. (FDIC) insures banks, while the National Credit Union Administration (NCUA) insures credit unions. If you open a CD with an FDIC- or NCUA-insured institution, up to $250,000 of your deposits with that institution are guaranteed by the US government in case of institutional failure.


The probability of bank failures is low, but it's comforting to know that such an event wouldn't endanger your funds. To ensure maximum safety for your funds, choose an institution that carries FDIC or NCUA insurance and avoid exceeding $250,000 in deposits at any single institution. If your deposits exceed this amount, you can maximize your coverage by spreading your funds across multiple institutions and/or names.

When to Consider Opening a CD?

CDs come in handy in several scenarios. Suppose you have some extra cash that you won't need immediately but plan to use in the next few years, perhaps for a special vacation, a new home, car, or boat. In such cases, the stock market is generally not a recommended investment as there is a risk of loss over such a short period.

Alternatively, you might just want a portion of your savings invested very conservatively, or you might prefer to avoid the risk and volatility of the stock and bond markets altogether. Although CDs lack the growth potential of equity or debt investments, they don't pose a risk of downturns. For money that you want to guarantee will increase in value, albeit modestly, CDs can be the right choice.

CDs also serve as a useful tool for disciplined saving.The discipline and low-risk associated with CDs make them an excellent choice for individuals who struggle with saving money. When you purchase a CD, you commit to leaving your money in the bank for a set period. The potential of facing an early withdrawal penalty can deter you from touching the money prematurely. This 'forced' discipline can be helpful for individuals who have the means to save but struggle to resist the temptation to spend.

Drawbacks of CDs

Despite their numerous benefits, CDs are not without their drawbacks:

1. Inflation Risk: One of the significant drawbacks of CDs is the risk of inflation outpacing the return on your investment. This issue is particularly prevalent when inflation rates are high, as they were during 2022 and 2023. If the inflation rate exceeds the interest rate you're earning on your CD, the purchasing power of your savings will diminish over time, even as your account balance grows.

2. Liquidity Risk: CDs are not as liquid as checking or savings accounts. You commit to leaving your money in the bank for a specified term, during which you may face penalties for early withdrawal. Therefore, CDs may not be the best option if you think you might need access to your funds before the end of the term.

3. Opportunity Cost: When you lock your money in a CD, you could miss out on higher returns from other investments. CDs offer lower interest rates compared to investments like stocks and bonds. Although the latter carry more risk, they also have the potential for much higher returns.

Despite these drawbacks, CDs can still be an effective part of a balanced financial strategy, especially for individuals who prefer safer, more predictable investments. They can also serve as a conservative part of a larger, diversified investment portfolio.