What are CDs and when are they helpful?

Have you heard of financial Certificates of Deposit but not quite sure how they work? They may be a good option when you are saving for a large purchase, looking for a low-risk investment, have money sitting in savings you don't need immediately or have received a monetary windfall.

What is a financial Certificate of Deposit?

Certificates of Deposits are commonly known as CDs in the financial industry. Many financial institutions offer them to customers as a form of investment. The CD typically has a minimum balance amount, is for a finite term, and has a higher interest rate than a standard savings accounts. Once created, the customer is locked into the terms. Depending on the financial institution they may recieve a physical certificate declaring their deposit. Upon the end of their stated term, the customer will return the certificate to the bank to receive their money plus interest. If money is removed from the account term early, per the terms of agreement, a penalty fee will be imposed.

How are CDs utilized by customers?

If you’ve never had a CD before it can be difficult to visualize within which situations it may be useful. The following sections will share scenarios highlighting different ways people have used CD’s in the past.

Timed Savings fund – One popular reason to open a CD is to save for a downpayment or upcoming large purchase. Below are few example scenarios.

• Saving a downpayment: You have saved your down payment on a house but its December and you don’t plan to start looking for a house until April. This is a good time to put the funds into a 91 day CD to gain higher interest on the amount and still have the funds available when its time to make the purchase. You can do this for any type of down payment you have been saving, such as, for a boat, car, RV, etc.
• Saving for your retirement: You are getting ready for retirement and decided to downsize your home! You sold your big family home and were able to purchase a new, smaller home with the funds, while still saving $100,000 from the sale of your house.  You plan to retire in just over a year and want to save the money for your second home in Florida. This might be a good opportunity to put the $100,000 into a 12 month high yield CD. Many high yield CD’s have higher minimum balance amounts, such as $100,000, and therefore offer larger returns.
• Saving for your dream vacation: You’ve saved a lump sum and plan to continue saving towards your dream of renting an RV, piling the family in, and traveling the United States; or perhaps you and your spouse dream of going on a world cruise; or maybe, you want to live in a foreign country for 3 months and experience a new culture. Since the dream is still three years away, now might be a good time to put the funds you have saved into a three-year CD. This will allow those funds to grow with the higher interest rate, while you continue saving towards your goal in your separate savings account.

Gift of money – Many times major life events are marked with the giving and receiving of money. Examples are high school or college graduation, engagement parties and weddings, and inheritances. You may benefit from utilizing a CD for a certain length of time while you decide what the best use of the funds may be. Below are two example scenarios.

• Tying the knot:  You just had your wedding and received a few thousand dollars in gifts. You and your spouse have decided to save the money for your honeymoon next year! Instead of holding the money in a savings account at a very low interest rate, this is a good time to put it into a 12-month CD. The funds will earn a higher interest and increase over the 12-month period but still be available in time for your trip.
• Graduation: Your family and friends celebrated this milestone with you and generously gifted you funds towards your future. Perhaps you plan to attend college in the fall, are taking a gap year, or are heading directly into the workforce. For some this might be the most money they have ever had in hand at once. To avoid it “burning a hole in your pocket” and spending it all, putting it into a 91 Day, 182 Day, or longer CD may be a good choice. It will gain interest and you can choose the term that works best for your future needs.

Low risk investment – CD’s are guaranteed investments. They are FDIC insured and as per your terms of agreement will gain interest at the ensured rate designated when the account is opened. The rate will not fluctuate and typically will not match the stock market rates. This makes CD’s a very safe method of saving funds for a short amount of time (typically withing a few years or less).  All the scenarios described above receive these same benefits as does the below scenario.

• Significant savings: You have saved a large sum in your savings account. Perhaps you’ve sold some assets, received an inheritance, or have been saving a certain amount every paycheck into your account. As part of your financial plans, you have decided not to put it into riskier investments. A CD might be a good fit as you will gain interest while still saving the funds.

Certificates of deposit are another way that you can make your money work for you. Before securing your funds in a CD be sure to talk to your customer service representative about the terms and early withdrawal penalties. Ensure you understand the information so that you can make the most informed decision about if a CD is right for you.

Learn about Northwestern Bank's CD rates here.

Calculate your CD rates of return with our CD Calculator here.

Learn more about personal finance on the NB Blog here.