What is a CD?
A CD is short for certificate of deposit. A certificate of deposit (CD) is a product that allows savers to earn interest on the money they deposit at the bank. Most CDs are FDIC insured (or by the NCUA if a credit union) which makes it one of the safest investments available.
A CD is also known as a Time Deposit. That's because a saver gets to lock-in an interest rate in exchange for keeping the money in the bank for a specified period of time. The amount of time is known as a Term or Term to Maturity.
The normal CD terms that can be chosen are 3 months, 6 months, 1 year, 2 years, 3 years, 4 years, and 5 years. There are of course other CD terms, but those are the most common.
Be Aware of the Early Withdrawal Penalty
A penalty may be incured for withdrawing the original deposit (called the principal) before the maturity date. However, many CDs will allow savers to withdraw the interest earned each month without penalty.
What is a Minimum Deposit?
Many CDs will have what is called a minimum deposit requirement. That is the least amount of money you are allowed to deposit in order to open an account. The minimum amounts differ by bank -- some require less than $1 and others require over $10,000. Jumbo CDs are certificates of deposit that require at least $100,000 to open.
A CD with a higher minimum deposit requirement does not necessarily have a higher interest rate.
The interest rate is how much the saver will earn in one year expressed as a percentage of the principal amount. The interest rate does not take into account the effects of compounding. So if a saver withdraws the interest earned every month, at the end of the year, her rate of return will be the interest rate.
However, even more money can be earned by leaving the earned interest in the account. This is due to compounding.
Compounding is when interest earned is reinvested with the principal amount and then interest is paid on the combined balance. That means savers are earning money not just on the cash originally deposited, but on the money the bank has paid.
Banks can compound daily, monthly, quarterly, or yearly. The more times money is compounded, the more money can be made.
APY - Annual Percentage Yield - The Way to Compare CD Rates
The interest rate combined with the effects of compounding is called the annual percentage yield or apy for short.
It is more efficient to compare different CDs using apy instead of the interest rate because not every account compounds with the same frequency. Two accounts can have the same interest rate, but an account that compounds daily will have a higher apy than an account that compounds quarterly.
Two account can even have different interest rates, but if the account with the lower rate compounds at a higher frequency, it might actually have the same or even higher apy than the account with a higher interest rate.