How Does A Certificate Of Deposit Work?

Want a savings account with a relatively higher interest rate? Read along to know your options!

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Often people invest in savings accounts to get a higher rate of return on their investments. The amount multiplies as per the interest rate that is set at the beginning of the transaction.

One such very reasonable option that most people find is to invest in a CD account- also known as the safest savings account there is.

Let’s get into details of what it is and how it works.

Certificate of Deposit Definition

Certificate of Deposit, widely referred to as CD, is a type of savings account which has people save- or invest- in it. The process is the same, like any other bank account: you put your money in, they pay you an interest rate on whatever you’ve invested. The biggest advantage of a CD account is that banks pay you a higher interest rate than what you’d get in a normal savings account.

Sounds great, right? You’re getting a relatively higher rate returned to you when the time comes.

However, there’s a catch. With every great offer, comes a price. And in the case of a CD account, the price is that you have to agree to lock your money up for a time period.

The bank will agree to pay you a higher rate of interest on the condition that you have to lock up your money with them for a couple of years. Yes, it is possible to extract your money before the time period ends, but chances are you’ll have to pay a very high penalty.

How does a Certificate of Deposit work?

A CD account works like any other account that you have in your bank or credit union- the only difference is the term and a relatively higher rate of interest that you’re being offered.

There are a few important elements of a certificate of deposit for it to work:

Interest Rate: A fixed rate of interest is great, because it gives an unmistakable and unsurprising profit for your deposit throughout a particular time span. The bank can’t later change the rate and thus lessen your profit. On the other side, a fixed return may take away the opportunity to take advantage of higher-paying CDs.

The term: This is the timeframe you consent to leave your assets and deposit to save you from any penalty (e.g., half year CD, 1-year CD, 18-month CD, and so on) The term closes on the maturity date when your CD has completely matured and you can withdraw the deposit without any charge of penalty.

The principal: With the exception of some specialty CDs, this is the amount you agree to deposit when you open the CD.

The institution: The bank or credit union where you open your CD will determine aspects of the agreement, such as early withdrawal penalties (EWPs) and whether your CD will be automatically reinvested if you don’t provide other instructions at the time of maturity.

Certificate of Deposit Example

There are a couple of examples of a certificate of deposit to help you understand what the fuss is all about.

Adam invested $5,000 in CD with the bank at a fixed interest rate of 5% and maturity in 5 years. The Returns and maturity value of CD is calculated as below:

Year Amount Interest
0 5,000 0
1 5,250 250
2 5,513 263
3 5,788 276
4 6,078 289
5 6,381 304

So the principal amount is $5,000, and the maturity proceeds are $6,381. The return on CD for the period of 5 years is $1,381.

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Certificate of Deposit Calculator

As mentioned, the certificate of deposit is calculated considering the APY- which is the Annual Percentage Yield, which depends on the frequency of compounding and the interest rate. Since APY measures your actual interest acquired every year, you can utilize it to look at CD’s of changed loan fees and building frequencies.

Yearly rate yield (APY) is determined by utilizing this formula: APY= (1 + r/)n – 1. In this equation, “r” is the stated annual interest rate and “n” is the number of compounding periods each year.

Interest Amount Formula:

The interest earnings in a certificate of deposit is determined by the following formula:

P × [ (1+rn)t×n−1] x P×[(1+rn)t×n−1]

Where:

P is the initial deposit amount, r is the annual interest rate in decimal form, n is number of compounding periods per year and t is the number of years the money is invested for.

This is a simple manual breakdown of a certificate of deposit and how the values are calculated. If you want to run the numbers online, you can do so through an online certificate of deposit calculator. Just enter the relevant figures inside the blanks and the algorithm will run, giving you an estimated number of what return you shall expect by the end.

Certificate of Deposit Rates

According to BankRate, these are certificates of deposit rates as per the three-month trend of interest rates in 2020.

Date 1-year CD 5-year CD 1-year jumbo 5-year jumbo Money market account
12/2/2020 0.24% 0.40% 0.26% 0.41% 0.10%
11/25/2020 0.24% 0.41% 0.26% 0.42% 0.10%
11/18/2020 0.24% 0.41% 0.27% 0.42% 0.10%
11/11/2020 0.24% 0.41% 0.27% 0.42% 0.10%
11/4/2020 0.24% 0.41% 0.27% 0.42% 0.10%
10/29/2020 0.25% 0.41% 0.27% 0.42% 0.10%
10/22/2020 0.25% 0.42% 0.28% 0.43% 0.10%
10/14/2020 0.26% 0.43% 0.29% 0.44% 0.10%
10/7/2020 0.27% 0.43% 0.29% 0.44% 0.10%
9/30/2020 0.27% 0.43% 0.29% 0.45% 0.10%
9/23/2020 0.28% 0.44% 0.30% 0.45% 0.11%
9/16/2020 0.28% 0.45% 0.31% 0.46% 0.11%
9/9/2020 0.29% 0.46% 0.32% 0.47% 0.11%
9/2/2020 0.29% 0.46% 0.32% 0.47% 0.11%

 

Best 1-year CD rates

Bank Rate Minimum Deposit To Open
Limelight Bank 0.65% APY $1,000
SchoolsFirst Federal Credit Union 0.65% APY $20,000
Live Oak Bank 0.50% APY $2,500

Best 2-year CD rates

Bank Rate Minimum Deposit To Open
Delta Community Credit Union 1.00% APY $1,000
Navy Federal Credit Union 0.90% APY $1,000
First Internet Bank of Indiana 0.75% APY $1,000

Best 3-year CD rates

BANK RATE MINIMUM DEPOSIT TO OPEN
Delta Community Credit Union 1.15% APY $5,000
Navy Federal Credit Union 1.05% APY $1,000
SchoolsFirst Federal Credit Union 0.90% APY $20,000

Best 4-year CD rates

Bank Rate Minimum Deposit To Open
Golden 1 Credit Union 0.95% APY $500
VyStar Credit Union 0.90% APY $500
First Internet Bank of Indiana 0.86% APY $1,000

Best 5-year CD rates

Bank Rate Minimum Deposit To Open
Delta Community Credit Union 1.35% APY $1,000
Golden 1 Credit Union 1.05% APY $500
First National Bank of America 1.00% APY $1,000

Note: Sample rates have been extracted online, courtesy of BankRate.

Certificate of Deposit: Can you add to the Balance regularly?

In the case of a regular certificate of deposit account, it is generally that you can’t add any more balance to the account other than what you’ve deposited initially. It’s no secret that steady deposits are one of the best ways to accumulate savings. And with money market accounts you can add money on a regular basis. CDs, on the other hand, generally don’t give you the option to make regular deposits.

An add-on CD is a type of certificate of deposit offered by banks and credit unions to store your savings. Generally, traditional CDs won’t let you add any more cash to the account after your initial deposit.

Conclusion

Imagine having a savings account that offers you a higher interest rate than other accounts, so when the time comes, you have a lot more than just what you initially deposited. The CD- account- a certificate of deposit account helps you multiply your savings by a HUGE amount.

The only ‘disadvantage’ as most people would call it, is that you have to lock up your money for a specific term. This isn’t an issue to most people who are willing to let the policy mature for the term and don’t intend on withdrawing anyway. Banks and credit unions offer a higher interest rate on the condition that you’ll lock it up for a term, because they also have a time period to loan the money to other people, without you coming in for it the next week.

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Charles Bains

Charles Bains

Charles Bains started his insurance career as a marketing intern before pounding the pavement as a commercial lines agent in Orlando, FL. As an industry journalist, his articles have appeared in a variety of trade publications. His insurance television career, short-lived but glorious, once saw him serve as the expert adviser on an insurance-themed infomercial (yes, you read that correctly). Having recently worked for various organizations, coupled with his broader insurance knowledge, Charles is able to understand our client’s needs and guide them accordingly. He is a gem for Insurance Noon as his wide area of expertise and experience have been beneficial in conducting further researches to come up with solutions and writing them in a manner which is easy for everyone including beginners to comprehend.

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