In mainstream culture, the term "CD" is used interchangeably with "compact disc" but in banking a CD is something different entirely. In personal finance, "CD" stands for "certificate of deposit," which is a special type of interest-bearing account that you can open at financial institutions such as banks, credit unions and savings and loan associations. Certificate of deposit accounts are a common alternative to standard savings accounts.
A CD is similar to a standard savings account in that you deposit money with a financial institution and earn interest on the deposit. The primary difference between a CD and standard savings account is that you have limited access to your money. CDs have a predetermined maturity date and if you withdraw your money before the maturity date, you typically face an early withdrawal penalty that forces you to forfeit some of the interest your account earned. If you keep your money in the account until the maturity date, you get your original deposit back plus all the interest it earned.
CD Interest Rates
The main reason people save money in CDs is that they tend to offer higher interest rates than traditional savings accounts. With a CD, you commit your money for a certain predetermined time, but the bank rewards you for the commitment with a higher interest rate than is available for a traditional savings account. In general, the longer the duration of a CD, the higher the interest rate. For example, a 1-year CD is likely to accrue interest at a lower interest rate than a 2-year CD. CDs are typically available with maturity dates that include 6 months, a year, two years or five years in the future.
CDs offer higher returns than savings accounts and more safety than investments such as stocks and mutual funds. The Federal Deposit Insurance Corporation can insure CD balances of up to $250,000, meaning you won’t lose your money even if your bank falls on hard times, as long as your bank carries FDIC insurance on its CDs. Another potential benefit of CDs is that interest rates are locked in until the maturity date, which can allow you to keep earning a high interest rate even if interest rates fall in the future.
While CDs offer a variety of attractive benefits, they carry several disadvantages. Since money in a CD earns interest at a fixed rate, you might lose out if interest rates rise after you open your CD. If you have an immediate financial need that forces you to withdraw your money early, you will likely forfeit some of the interest. In addition, investments such as stocks and mutual funds offer better growth potential than CDs, albeit with the cost of higher risk.
Money market accounts are an alternative type of deposit account that offer interest rates that are higher than standard savings accounts but let you withdraw money without penalty. CDs can offer interest rates that are slightly higher than money market accounts, especially if you commit to a CD that lasts longer than a year, but a money market account can be a good option if you might have to access funds before the maturity date of a CD.