CDs 101: The basics

Curious about certificates of deposit, but not sure where to start? Learn the basics and print out an 8-point checklist to help you decide if a CD is right for you.

Certificates of deposit, or CDs, aren't as complicated as they sometimes sound. If phrases like "breaking a CD" and "early withdrawal penalty" make you nervous, it's time you learned more about CDs, how they work, and how they might fit into your financial portfolio. Learn the basics and 8 key points to know:

What is a CD?

A CD is a type of deposit account that usually offers a higher interest rate than a traditional savings account. When you buy a CD, you invest a set amount of money for a set amount of time. In exchange, the bank typically guarantees you a set rate of interest. When your CD matures, or reaches the end of the set amount of time, you receive the money you invested plus any earned interest.

How do CDs earn money?

It used to be the norm that CDs paid a fixed interest rate when they matured, but now a host of new options are available, including variable rate CDs, long-term CDs and CDs with special redemption features for heirs should the investor pass away.

What happens when CD rates change?

Be sure to find out if a CD has "call" features. Some high interest, long term CDs can be called, or terminated, by the bank after a specified period of time. If CD rates fall, a bank might decide to call its high-yield CDs. Only the bank can call a CD, however, so if you've invested in a CD and interest rates go up, you will still be locked in at the lower rate until the CD matures.

Are CDs safe?

Unlike most other investment vehicles, the FDIC insures CDs from FDIC member institutions up to $250,000. It's important to note that federal deposit insurance is limited to a total aggregate amount of $250,000 for each depositor in each bank or institution. This means that if you have multiple accounts in your name at the same bank, FDIC only covers the first $250,000 of all the accounts added together.

What happens if I need to redeem my CD early?

Unplanned expenses happen. If you redeem, or break, a CD before it matures, you typically pay an early withdrawal penalty or give up some of the interest you earned. Terms will vary, so read your bank's disclosure document carefully. Be sure to keep adequate cash reserves in a savings or money market account to reduce the chances you'll need to break your CD.

Where can I buy a CD?

Traditionally, investors bought CDs at their local bank branch, but now CDs are available from online banks, and some brokerage firms are starting to offer CDs as well. These brokerage firms, or deposit brokers, can often negotiate higher CD rates in exchange for committing to bring business to the lending institution. The "brokered CDs" with the higher interest rate can then be offered to the broker's customers.

Before you buy: Eight-point checklist

Before buying a CD from your bank or a brokerage firm, you'll probably compare interest rates on CDs. But make sure you read the fine print and understand the terms, as well. High interest rates are nice, but don't let that be a reason to forego your own research. Use the following 8-point checklist based on the FDIC's Tips for Savers to get to know the CD and its financial institution before you buy:

1. Know when the CD matures. According to to the FDIC, "many investors fail to confirm the maturity dates for their CDs and are later shocked to learn that they've tied up their money for five, 10, or even 20 years." Confirm the maturity date in the written materials.
2. Ask about automatic rollover. Rollover is when a bank automatically renews a CD at the same term upon maturity. Not all CDs roll over, but it's important to know if yours will so you can cash out if you need to before it automatically renews and ties your money up for another CD term.
3. If you're considering a brokered CD, identify the bank or institution. Find out where the broker will deposit your money, and ask what record-keeping procedures are in place to be sure your investment will be FDIC-insured.
4. Understand the call features, if any. A callable CD means the bank can choose to terminate it before maturity, but you don't have the option to terminate it early. It's worthwhile to talk to a bank or institution representative to have the call features fully explained.
5. Confirm the interest rate. Your disclosure document should tell you the rate and whether it's fixed or variable. If it's variable, find out when and how the rate might change.
6. Know how and when you'll be paid. Does the bank pay interest monthly or quarterly? Will you be issued a check, or will the money be directly deposited into your checking account or back into the CD?
7. Find out about penalties for early withdrawal. If you have to break your CD, it's important to know how much you'll have to pay for cashing it in early.
8. Ask if your broker can sell your CD. Some deposit brokers advertise CDs with no penalty for early withdrawal. If you want to redeem the CD early, the deposit broker will resell your CD. If interest rates have fallen since you bought the CD, you could sell it for a profit. Conversely, if interest rates have risen, you'll probably have to sell at a loss.

Consider your financial situation to decide if CDs are right for you. If you think you might need the cash in the short-term, consider a different savings account, a shorter CD term, or buying several smaller CDs and starting a CD ladder.

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