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What Is a Certificate of Deposit and How Does It Work?

what-is-a-certificate-of-deposit-and-how-does-it-workA certificate of deposit (CD) is a great opportunity to save money faster so you can achieve your financial goals.

When you earn higher interest than conventional savings accounts, you can reach your financial goals sooner. In exchange for higher interest rates, you agree to hold your deposit in the account for a fixed period of time. However, what you give up in flexibility, you gain in savings.

CDs typically have a guaranteed rate of return, so you can save for a dream vacation, wedding, down payment on a home, new car, education, and more. Keep reading to learn the benefits of CD investing and how to calculate certificates of deposit interest. Accelerate your savings and ensure the money is there when you need it.

What Is a Certificate of Deposit?

A certificate of deposit is a type of savings account that pays a fixed rate on a lump-sum deposit that is held in an account for a fixed period of time. They differ from traditional savings accounts because the money must remain untouched for the agreed-upon period of time to avoid early withdrawal penalties. This period can range anywhere from four months to five years, depending on the financial institution. Once your CD reaches maturity, you can withdraw the full amount without penalty. Even though CDs offer less flexible withdrawal terms, banks exchange higher interest rates to incentivize holding money in your account.

When you open a certificate of deposit, you agree to the terms and conditions outlined by your preferred bank. Make sure to read these terms carefully and choose the option that best suits your goals, budget, and lifestyle. Do you need your money in a few months, or can you comfortably live without it for several years? Typically, rates increase the longer you agree to leave your money in the account.

Understanding How a Certificate of Deposit Works

When choosing which CD works best for your particular goals, you will review the length of the term, how much interest it earns, and the minimum deposit needed to open an account. Most CDs have a fixed rate, which means your rate of return is guaranteed. However, some banks offer variable CDs with adjustable interest rates.

The term is the length of time you agree to leave your money deposited. The specific terms vary depending on where you open an account, but common CD terms can range from 3 or 6 months to 1 year, 18 months, or even up to 5 years.

Short-term CDs are typically less than one year and require less commitment while offering more flexibility. If your CD expires and you still don’t need your money, you can renew it as many times as necessary. Or you can withdraw your funds once you’ve reached the maturity date. This is ideal for anyone with a short-term savings goal, such as saving up for an upcoming vacation, anticipated birth, or wedding. Keep in mind, shorter terms often mean lower rates unless your bank is offering promotional CD rates.

Conversely, long-term CDs typically offer higher rates in exchange for longer terms. If you can afford to comfortably live without your deposit for two to five years, you can unlock better interest and save faster. Just make sure you don’t need the money sooner, otherwise, you risk a penalty fee for early withdrawal. Long-term CDs may be ideal for saving for an emergency fund, a down payment on a house, education, or any other large expense you are saving for in the near but not immediate future.

How to Calculate Certificate of Deposit Interest

Once you’ve selected the term that is right for you and made the minimum deposit, your account will begin to earn interest. Earnings are usually deposited in monthly or quarterly payments. When your account matures, you can withdraw your funds, roll them over to a new CD, or transfer the money into another account.

If you are unsure which CD is right for you, you can calculate the interest to determine which terms and rates will help you reach your financial goals. Follow the steps below to determine how to calculate certificate of deposit interest:

  1. Gather your numbers: principal (initial deposit amount), term of CD (how many months), and annual percentage yield (APY).
  2. Multiply the CD balance by the APY.
  3. Add the answer to number 2 to the principal to calculate the CD value for the first year.
  4. Repeat the process for any additional years.

Another way to calculate interest is to take the APY and divide it by 12 (number of months in a year) to determine monthly interest. Then multiply by the number of months in your term and apply it to the principal amount. Or use a free online CD calculator to determine interest.

Benefits of a CD

Opening a CD account has a myriad of potential benefits for managing your financial goals. Some of the main advantages include:

  • Safe investment tool: The Federal Deposit Insurance Corporation (FDIC) money held in your account is insured up to $250,000 per person on the account. Invest your money with little risk of losing it and greater potential for earnings. This is ideal if you are risk-averse or cannot afford to risk your money in stocks. CDs can function as a low-risk investment tool so you can safely accelerate your savings.
  • Guaranteed returns: Predict how much interest you’ll earn and easily manage your savings goals. With fixed terms, you will be able to calculate the accrued interest.
  • Higher interest rates: Earn more interest compared to conventional savings and money market accounts.
  • Less risk of spending: Your deposit is held in an account, removed from the temptation to spend prematurely before reaching your savings goal.

When you’re ready, grow your savings with Riverview Bank’s competitive CD rates. Visit a branch or visit us online to discover the CD that is right for you. We are here to help you save faster so you can expand your options for the future.