What is a CD Account and How Does it Work?

Investing


You’ve probably heard of a CD account before but you don’t really know what it is.  A CD account, also called a certificate of deposit account, is a loan that you make to a bank for a fixed amount of time.  Certificate of Deposit accounts are known to be one of the safest investment vehicles.  In return for your loan, a bank will give you interest on your loan.  That is where the term CD account comes from,  you get a certificate of deposit once you agree to loan the bank the money.  The interest rate of CD accounts increase with the amount of time you agree to loan the bank.  The interest rates of CD accounts are usually higher than the interest you will receive from your checking or savings account.  Most CD accounts have terms from 3 months to up to 10 years and are insured by the FDIC up to $250,000.  Along with having your money in a CD account longer for higher interest rates, you can also choose to put more money in your CD account to receive higher interest rates.

What is the difference between a CD account and a savings account?

Well a CD account will generally pay more interest.  Also, with a savings account you can take your money out anytime.  With a certificate of deposit account, you will generally pay a penalty if you take your money out before the loan terms expire.

The CD laddering strategy

Many experienced CD account investors recommend the CD laddering strategy when investing in certificate of deposit accounts.  The laddering strategy is a lot like the average-cost strategy of stock investing.  The point of the CD laddering strategy is to not put all your money into one CD account but rather you spread your money into different time horizons and reinvest the CD accounts that mature first.  Here is a great illustration of how CD laddering works, brought to you by Ally:

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cdladdering illustration

Here’s how laddering CDs works:


You go to the bank with $50,000 and spread your investment into 5 equal CD accounts.  You will have $10,000 in a 1 year CD, a 2 year CD, a 3 year CD, a 4 year CD, and a 5 year CD.  Each year is essentially a step up the ladder.  When the first CD account comes to maturity, you reinvest that money in a new five-year CD because by that time all your CD accounts will have matured one year—meaning your old 5 year CD is now a 4 year CD.  And rinse and repeat—meaning as each and every one of your CD accounts matures, you reinvest it in a new 5 year CD.

This laddering strategy has been known to be one of the best ways to get liquidity out of a CD investment and also one of the best ways to get a higher rate of return on your certificate of deposit.  Given enough time, the laddering strategy gives a better return on investment than just investing in any one particular CD.

Where to find the best CD rates

Rates will vary from one financial institution to another.  It is not just banks that carry Certificates of Deposits.  Insurance companies also carry CD accounts.  So be sure to check out all your options.  There are several sites that offer pretty good comparison tools you can use to pick out high interest CD accounts.

What is my Recommendation?

I have done my own research in several websites and called several banks. The true story is that the difference in CD rates does not change a lot if you are depositing less than $ 1M (which is my case). After realizing that, I decided to choose to create my CD account at BBVA because it was the one that offered the best service, rate and benefits overall. If you don’t want to spend a lot of time researching this, BBVA is a great alternative. Good luck with you CD deposits!

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