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What is a Certificate of Deposit (CD) and How Do They Work?

During times of market volatility, like those we’re experiencing today, many individuals interested in building their nest egg, or saving for a specific goal, look for alternatives that offer less risk and more stable returns than traditional stocks and stock-based accounts. While CDs have often been written off in the recent past for their low-yields, today’s high interest rates, coupled with the low-returns of the stock market, have once again made them a popular savings tool.

So, what are the benefits of certificates of deposit and why are CDs better than other savings accounts? CDs not only offer higher interest, but as a guaranteed product, their stability proves them to be especially useful during times of uncertainty. If you’re looking for an alternative investment to ride out market volatility, consider certificates of deposit as a safe and profitable alternative. But first, let’s discuss what they are, exactly.

What is a CD?

A certificate of deposit, or CD, is a type of savings account that has a fixed interest rate and fixed term (length) of deposit. When you open a CD, you will choose your term length from a selection of offerings, often ranging from a few months to a few years. During this time, you won’t be able to access your deposit as it grows—if you do need to withdraw funds early, you will have to pay a penalty, forfeit your interest, or possibly both.

Because these funds aren’t generally available, that frees them up for banks to utilize in their own lending practices, meaning that you will earn a higher interest rate than on other kinds of savings accounts that have greater liquidity, like a statement savings account. This is why, especially when rates are high, CDs make great mid-term investments.


How CDs Work

CDs are similar to bonds, in that when you open a CD, you will know exactly how much it will be worth when it matures. That’s because both the interest rate and term length are locked in the minute you make your deposit. However, CDs are bank products—not issued by the government or corporations like bonds. Banks have specific term length selections, as well as set interest rates. Rates tend to be higher for longer CDs, or CDs with larger deposits. Let’s take a look at some common questions about CDs to learn more about how they work as savings products.

How are interest rates determined?

While different CD offerings may have different interest rates, all rates are influenced by market interest rates.  Union Bank uses the federal funds rate as one of the tools to set the rate of its CD’s. Right now, the federal funds rates are higher than they’ve been in a long time. With the current economic environment and the Federal Reserve Bank increasing the federal funds rate, now is a great time to purchase a CD! In fact, as of the time of the publishing of this article (November 2022) Union Bank is offering a 16-month CD special with an interest rate of 2.79% and an Annual Percentage Yield (APY) of 2.83% (with a minimum opening balance of $25,000.00).

How long should I keep a CD?

As we mentioned above, generally the longer you keep your money in a CD, the higher the interest rate you will receive, which makes a great case for choosing a longer term. However, keep in mind that you won’t be able to access your funds until your CD matures, so be sure you will not need any of that money in the near term. If you are saving for a significant purchase, like a car or house, and know you have a set amount of time until you’re ready to buy, putting what you’ve already accumulated into a CD that matches your savings period is a great way to earn extra interest, while reinforcing your savings goal time frame.

Are CD earnings taxed?

The interest that you earn on CDs is considered income, so you will be required to include it when you file for taxes. Your bank will typically send you a 1099-INT statement, or a statement of earned interest, which you can use when you file for your taxes.

What happens when my CD reaches the end of its term?

When your CD reaches the end of its term you will need to decide what to do with the funds. You can take the principal and accrued interest in cash, or choose to reinvest the funds in a new CD (also known as “rolling over” the CD). If you don’t take steps to cash out your CD, many CDs will automatically renew with the same term length, but at current interest rates, though don’t worry—your bank will notify you in advance, and CDs do have a grace period after they mature before they are renewed. Before deciding to reinvest or allow your CD to automatically renew, consider whether interest rates are rising or falling and if you can earn a higher rate of return elsewhere. Speak to a Union Bank representative to see what current rates are available.


Advantages of CDs

CDs are a niche savings product with a lot of benefits, especially for certain uses. While they don’t match every saving and investing need, here are a few of the advantages they offer:

  • Safety.  Traditional CDs are insured by the FDIC for up to $250,000 per account, making CDs a very low-risk investment.
  • Predictability. CDs offer a guaranteed interest rate and return. Your interest rate will remain the same as the day you open the account, even if general CD rates go down, and because the term length is also fixed, you can calculate the matured value of the account from day one.
  • Better rates. Especially when interest rates are high, CDs may have significantly higher APYs (annual percentage yields) compared to standard savings or even money market accounts, especially for long-term CDs.
  • Flexible investing. With CD laddering, you can create a flexible investment strategy that allows you to take advantage of the interest rates of long-term CDs, while also gaining access to your capital on a regular basis. CD laddering allows you to open multiple CDs of different lengths that mature in succession, allowing you to both access funds regularly. and take advantage of longer-term interest rates. Roll over CDs as they mature to keep building your investment, or cash them in as needed.

Disadvantages of CDs

As we mentioned above, CDs have a lot of benefits, but they aren’t the perfect fit for every savings need. They can be more restrictive than other investments, and depending on rates, might not give you the best return compared to other long or mid-term products. Here are some of the drawbacks of CDs:

  • Less liquidity. Because you won’t be able to access your funds until the maturity of your CD, it’s important to not lock away any funds you may need. This means that it’s unwise to put all your savings in a CD at one time. Be sure you have an additional liquid savings account for emergencies, or consider a high-yield savings account instead.
  • Opportunity cost. While CDs are low risk, they are also historically low yield, falling behind the returns on other investment products like stocks and bonds. If you’re young and saving for retirement you may prefer to put your money somewhere you can earn higher returns like an IRA or other investment products. While they do have a higher risk associated with them, accounts like IRAs also have higher average yearly yields, meaning your potential earnings could be much higher in the long run, despite occasional market dips.
  • Early withdrawal penalties. As we mentioned before, if you need the money before your CD comes to maturity, it will cost you. Some CDs have a specific early withdrawal penalty, while others will cost you all your earned interest. Each financial institution has its own specific rules pertaining to early withdrawals, so be sure to inquire before you open your account.


How to Open a CD

If you’re ready to try out a certificate of deposit, now is one of the best times to do so. In fact, current high interest rates make them a great investment alternative to stocks during today’s bear market. And you don’t need a lot of money to start—at Union Bank you can open a CD with as little as $100. And we have some of the best CD rates in New Hampshire and Vermont, too!

To learn more about CDs or compare CD products, visit our Personal Certificate of Deposit page. Still have questions? Contact us or stop by a branch in Berlin, St Albans, St Johnsbury, Shelburne, Fairfax, Hardwick, Jeffersonville, Jericho, Johnson, Lyndonville, Morrisville, Stowe, Williston in Vermont, or Littleton, Groveton or Lincoln in New Hampshire, to speak to a banking representative and open your own CD today!