Personal Finance: A guide to choosing CDs

Certificates of deposit, or CDs, are not exciting. In fact, that is often the best way to think about them.

They are not meant to drive a long-term investment strategy, and they may only barely outpace inflation. But they are useful for a narrower job: preserving principal and delivering a steady, predictable return over a defined period when taking on market risk is not an option.

A bank CD works like a contract. You lock up a lump sum for a set term, the bank pays a fixed interest rate, and when the term ends, you receive your original deposit back. That certainty can be helpful when planning for expenses with a known deadline, such as college tuition next semester or a home down payment due in the coming months.

By aligning a CD’s maturity with the timing of an expense, savers can gain some certainty while earning a relatively competitive, low-risk return that is backed by federal insurance, subject to certain conditions.

The idea of depositing valuables for safekeeping is ancient. In Mesopotamia around 2000 BCE, temples served as trusted places where merchants and farmers could store goods such as grain and silver. As banking developed, regulation followed closely behind. The Code of Hammurabi, dating to about 1754 BCE, included rules for items held in safekeeping and guidelines for allowable loan interest rates.

During the 15th century, the Medici dynasty in Italy helped make interest-bearing demand deposits more common. Similar quasi-public banks later emerged in Spain and the Netherlands, and the model eventually reached London with the founding of the Bank of England in 1694.

In the early United States, mutual savings banks took in small interest-bearing deposits and made modest loans. The National Bank Act of 1863 then created federally chartered banks and set up a regulatory structure for time deposits, the predecessor to the modern CD. The idea took hold.

According to the Federal Deposit Insurance Corporation, Americans now hold nearly $3 trillion in bank certificates of deposit.

How bank CDs work

Opening a CD at a bank or credit union means putting in a lump sum for a fixed term, often anywhere from three months to five years.

Interest accrues at a stated rate and is usually quoted as an annual percentage yield, or APY, which reflects compounding when interest is paid at maturity. Some banks instead pay interest monthly or quarterly, which provides regular income but typically does not compound.

Beyond the maturity date, CDs often limit early access to your money. Early withdrawals usually trigger a penalty, often equal to a portion of the interest earned, such as 90 days of interest on a one-year CD. If money is withdrawn very early, the penalty can even reduce the principal if the account has not earned enough interest to cover it.

Some CDs allow penalty-free withdrawals after a short initial waiting period, often seven days. Those accounts generally pay a lower yield in exchange for greater flexibility. It also pays to compare offers: online banks, with lower operating costs, often offer better rates than large branch-based institutions.

One common approach is the CD ladder. This means spreading money across CDs that mature at different times, such as three months, six months, and one year, to match expected expenses. As each CD matures, the money can be spent or rolled into a new deposit.

The safety of bank CDs depends on federal deposit insurance. The FDIC insures deposits up to $250,000 per depositor, per insured bank, if the institution fails. Credit union deposits receive similar protection through the National Credit Union Administration.

For one person with accounts at a single bank, the $250,000 limit applies across individual accounts, though separate coverage can apply to joint accounts, retirement accounts, and certain trusts. Before buying, make sure the institution is actually FDIC-insured.

Brokered CDs: a different animal

Most people are familiar with bank CDs, but brokered CDs are a different variation that can offer features not usually available with the traditional version.

Instead of gathering many small deposits from retail customers, a bank may want to raise a large amount of money at once. It can create a very large CD, sometimes worth millions, and sell it to a brokerage firm. The broker then breaks that master CD into $1,000 pieces for individual investors.

Unlike a bank-issued CD, a brokered CD can also trade in the secondary market, much like a stock or bond. Its market price depends on prevailing interest rates, so the investor’s return may include gains or losses based on the difference between the maturity value and the price paid, similar to a bond.

Brokerages let investors compare hundreds of FDIC-insured offerings from banks across the country, and the rates may be higher than those available locally. They also make it possible to spread money across many issuers to maximize insurance coverage. Instead of paying an early withdrawal penalty, an investor can sell a brokered CD before maturity on the secondary market. Interest is typically paid periodically rather than compounded, which can create ongoing cash flow.

Many brokered CDs also include a call feature, giving the issuer the right to redeem the CD at face value. Some include a survivor’s option, sometimes called a death put, which allows a deceased holder’s estate to redeem the CD at full value with interest even if its market price has fallen.

Choose a bank CD if you value simplicity and certainty. Consider a brokered CD if you already use a brokerage account, want a wider selection, prefer a bond-like secondary market, and can accept the possibility of price risk if you sell early in exchange for added features.

A CD may not be thrilling, but that is exactly why it can work.