How CDs Work

Putting some of your savings in a certificate of deposit is a way to earn a higher return than a savings account. You agree to take a certain amount of money and have the bank hold it for a specified period of time; at the end of that time, your money will be returned along with the interest that it earned. Some long-term CDs may allow you to withdraw the interest payments as they are earned.

The most common certificate of deposit terms range from three months to five years. The longer the term is, the higher the interest on the CD will be. Because CDs are a deposit account, each one is insured for up to $250,000.

A traditional certificate of deposit consists of a set amount of money that is deposited for a specified length of time (the term) and the interest rate that is determined at the time the CD is bought. Some banks let you add money to the deposit at the end of the term if you are rolling it over into another CD. If you withdraw the money before the end of the term, you pay a high penalty and lose your interest.

A bump-up certificate of deposit is a good option if the interest rate is rising. If during the term of your CD the bank starts to offer a better rate on like CDs, then you can request that the bank bump-up your interest rate for the rest of the CD term. Normally, you can only request this once during the term. The downside to this kind of CD is that you will normally start out with a lower rate than you would with a traditional certificate of deposit.

If you buy liquid CDs, you can take your money out without a penalty, but again, the rate will be lower than similar traditional CDs. There is also a waiting period is for withdrawal and a limit to the number of withdrawals you can make.

Zero-coupon CDs work like this: You buy a long-term CD valued at twice what you paid and with a certain interest rate. You don’t get any interest during the term of the CD. The drawback is that the IRS sees that accruing interest as income each year, even though you haven’t received it yet, and you will have to pay taxes on it annually.

Once the CD has reached its term, you can usually elect to roll it over into another CD with a new term. To open a certificate of deposit account, you can contact a bank or a brokerage that sells CDs. Compare rates and term offerings to decide what works best for you.

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