How a Certificate of Deposit (CD) Works

While a certificate of deposit (CD) is another form of savings account offered by most financial institutions, it operates in a very different fashion from classic accounts or money market accounts (MMAs).

Like MMAs, CDs typically offer higher interest rates than most other savings accounts. CD rates normally are affected by the banalce and length of commitment of the CDs you choose to purchase. Here are the primary differences between a CD and other savings accounts.

• They are purchased for a specific amount of money. Unlike traditional savings accounts that allow you to start your account with almost any amount of money or MMAs that specify a minimum amount, but allow increases at will thereafter, CDs are purchased for a specific amount of money as allowed by your bank or credit union.
• They have a specific maturity date. Savings accounts and MMAs are typically “evergreen” options, as they have no end and theoretically last forever or, at least, until you decide to close the account.
• They usually do not permit any additions to, or withdrawals from, your initial deposit. You should invest only monies that you should not need for the term of the CD and not funds that might be necessary for use.
• You will pay a penalty for any early withdrawals from a CD balance. If an emergency arises and you must have access to some or all monies in a CD, you will pay a penalty, possibly amounting to all the interest you have earned to date.
• A CD is actually a “contract” between you and your financial institution wherein you agree to keep an amount of money with them for an agreed period of time. In return, your bank or credit union agrees to pay you a stated interest rate, usually higher than any other savings account, for the term of the certificate of deposit.

A CD is a very effective way to earn higher interest rates, enjoy the protection of Federal insurance on your balance (up to $100,000), and select a time frame that works for you. CDs typically are offered in time segments of from six months to around five years. You can choose the contract times that fit your financial plans.

How a money market account (MMA) works

Money market accounts, offered by banks and credit unions, operate much like traditional savings options with a few important differences. A money market account (MMA) is insured by the FDIC (banks) or NCUA (credit unions) up to $100,000, just as are other savings accounts. The differences are few, but significant. Here are the primary MMA features than differ from traditional savings accounts.

• There are typically minimum balance requirements to open a MMA. Often a minimum deposit of from $1,000-$2,500 is needed to open a MMA and your balance is not permitted to fall below the account minimum.
• Money market accounts usually pay higher interest rates than classic savings accounts. These higher rates are a reflection of the minimum balance requirements and certain federally mandated money market account restrictions (see below).
• Only three to six withdrawals per month are permitted. This account is not designed to serve as a transaction vehicle. It is structured to pay you higher savings account interest while still providing some access to your money.
• You are allowed to write up to three checks per month to allow for remote payment of some obligations or investments.

Money market accounts offered by financial institutions should not be confused with money market mutual fund accounts (MMMFA) available through investment companies. There is no federal insurance available from an investment firm. In addition, instead of a form of savings account, these accounts are really short-term investments in equities (stocks), of which you own a percentage.

Elements of traditional savings accounts

Classic or traditional savings accounts are offered by every financial institution in the U.S. and throughout most of the world. In America, banks, credit unions, savings and loan associations, and mutual savings banks all offer one or more types of savings account. These options are designed to permit you to deposit and withdraw money with few restrictions and to earn interest at regular, specified intervals.

As use of the Internet increases, the online savings account is also becoming more popular. Since you can access these accounts on a 24/7/365 basis, you can transfer monies in and out of your accounts whenever you wish.

While you may have few restrictions on transactions and enjoy unlimited access, a savings account should rarely be used like a demand (checking) account. Those who try often find that the lack of “transaction” features, like checks, can make for a cumbersome bill paying ability.

Interest paid on a savings account may occur as often as daily or as rarely as annually. Typically the more often interest is posted to your savings account, the lower the interest rate will be. However, the wonderful effects generated by “compounding” may increase your APY (Annual Percentage Yield) on a daily or monthly interest posting account to a level close to the higher rates offered by less frequent interest postings.

Traditional savings accounts may also offer different options at the discretion of your financial institution. For example, you might be offered a savings account that has different interest rate levels depending on your balance. As your balance increases, you might reach levels (e.g., $2,500, $5,000, $10,000, etc.) that earn you higher interest rates.

You can use the ability to manage an online savings account to increase or decrease your balance to maximize your interest earnings with some of these more “interesting” savings options.

Fixed and liquid investments explained

Investments can generate thousands of words from hundreds of banking ”experts” from around the globe. It’s important to understand the difference between a fixed and liquid investment before you enter the more complex universe of “good” and “bad” investments.

Fixed investments have characteristics that differ from liquid investments, including the following tendencies:

• They tend to be “hard” investments, as with real estate, machinery, etc. that are not intended nor typically have the ability to be converted to cash quickly.
• They are typically long-term investments that are not easily converted to cash.
• They are made for growth, stability, and safety over the long term.
• There is no current plan to turn these investments into cash.

Unlike a fixed investment, a liquid investment has a more “current” purpose and has the ability be used quickly. Characteristics include:

• The ability to be converted into cash almost immediately.
• A lack of risk they will devalue during their time in your investment portfolio.
• The ability to be used to make other investments as their liquidity makes them available to you on short notice.

Liquid investments typically “earn” lower interest, dividends, or profits than fixed investments, but their immediate availability to be turned into cash gives you the ability to make other investments. Fixed investment items are intended to be longer term items that you have decided should be left alone to appreciate and gain value.

Differences between compound and annual interest

The subject of compound versus annual interest tends to confuse many consumers – with good reason. The concepts and procedures, however, are actually quite simple and straightforward. Instead of dealing with banking philosophy and theory, a simple savings calculator should clarify any confusing elements.

Example #1:
You deposit $10,000 in an account that pays you 5% interest annually (interest is posted once per year). If you deposit these funds on January 1^st, at the end of the first year, you will earn $500.00. Simple.

Example #2:
You deposit $10,000 at 5%, with interest posted (and compounded) quarterly. With compounding, you will earn $509.46 the first year of this account. This results in an APY (Annual Percentage Yield) of around 5.1%.

Compound interest, over time, will earn you a great deal more money on a deposit account than annual interest. An account that posts interest daily, weekly, or monthly will further increase the positive effects of compound interest. Understand this potentially important difference when you evaluate deposit accounts to determine which are the best choices for you.

Over long periods of time, as with retirement accounts or other long-term savings options, the effects of compounding can be huge. Even an account started with one penny with interest compounded daily will be worth millions of dollars over time.

When comparing savings rates, always take into consideration whether or not compound interest factors into the equation.

Recommended resource: Compound savings calculator

How FDIC insurance works

The Federal Deposit Insurance Corporation (FDIC) is both the primary regulatory agency for commercial banks and its account insurer. This combination of watchdog and protector has worked well for the most obvious reasons. By examining and evaluating commercial banks, FDIC has first hand knowledge of the operations, stability, and profitability of their institutions.

By having some measure of control over the “safety and soundness” of the banks they insure, the FDIC can more confidently issue their insurance coverage. This should make depositors more comfortable, too.

All banks who qualify for FDIC insurance have been deemed safe and sound by the agency. Certainly, FDIC encounters institutions enduring some problems. When they do, they offer suggestions – sometimes, mandates – to help correct issues that cause problems.

FDIC insurance is sometimes misunderstood. The critical issues are the maximum amount insured (usually $100,000) and the definition of “what” is insured. OK, so what is insured?

• Savings accounts
• Checking accounts
• NOW accounts
• Money market deposit accounts (MMA’s)
• Certificates of deposit (CD’s)

How is the maximum insurance calculated? This can be more complicated, but here is a simple outline.

• Single accounts = $100,000
• Joint accounts = $100,000 per co-owner
• IRA’s and some retirement accounts = $250,000 per owner

Update: Recent FDIC changes and how they affect you

If your bank fails and is FDIC insured, you will receive payments for your account balances up to these limits. But, remember any current interest earnings are not typically covered, as your “principal” is technically the insured amount. Should you have an account into which you deposit $100,000 and another on which you are a joint owner, also with a $100,000 balance, you should be insured for both accounts.

About the FDIC

The Federal Deposit Insurance Corporation, usually referred to as the FDIC, is the agency of the United States government responsible for insuring bank deposits and, by extension, the banks themselves. This coverage is mandatory for all banks and savings and loans that are members of the Federal Reserve bank system or are nationally chartered.

Savings accounts, checking accounts, money market accounts, and certificates of deposit can be insured by the FDIC – generally up to $100,000 per account. The FDIC does not insure stocks, bonds, mutual funds, life insurance, or annuities, even if purchased from an insured bank.

Usually, the bank itself will proudly display, online, in branches, and in its marketing materials, that its deposits are insured by the FDIC.  Consumers can also check whether a bank or savings and loan is insured by visiting the FDIC website.

Having this insurance is an important designation for banks. It indicates that the operations of the bank have been reviewed and that they met the standards of state and federal regulators. It also indicates that if a bank does fail, a consumer’s deposits will be insured, dollar for dollar, up to the limit of the account.

APY Explained

Most people who have borrowed money in the past two decades are familiar with the term APR (Annual Percentage Rate) and its implications. It displays the true interest rate you’re paying for the loan to which it applies. A more recent term, APY (Annual Percentage Yield) displays the true interest rate you’re earning for the account to which it is attached.

For example, a savings account paying 4.0% interest may actually be earning you more interest than the stated rate. Assume you deposit $5,000 in two accounts both paying 4.0% interest. One account posts interest once per year, on December 31. That account will earn you $200.00 for the year and your APY is 4.0%.

The second account, however, posts interest quarterly during the year. Through this quarterly posting and the magic of “compounding” (earning interest on interest), you’ll earn around $203.03 for the year. Your true earnings rate or APY is around 4.1% for the year.

APY calculations give you a better idea of what a certificate of deposit (CD), savings, checking, or money market account is really earning. In some cases, a stated rate of interest may be higher than an APY, but this situation is rare.

Prime Rate Information

Some banking consumers are aware of the term “Prime Rate,” but don’t understand its definition, except as a measurement or index from which other interest rates are compared. Actually, this understanding is important and gives potential borrowers good clues on how interest rates on autos, equity, and personal loans are trending.

Typically, when the prime rate goes down, other loan rates tend to decrease. Conversely, as the prime rate increases, consumer loan rates follow.

The prime rate, however, is really the elusive annual percentage rate that is offered to the best commercial loan borrowers. Prime rate is actually not the bedrock of all interest rates, contrary to some general perceptions. The “discount rate,” as set by the Federal Reserve, is “prime” index rate that tends to drive all others, from savings to loans.

The prime rate will be a bit higher than the Federal discount rate and many lenders will price their other loans using some percentage above prime. Lenders make this calculation, in concert with their competition, for most types of consumer loans.

Lenders wanting to increase their loan portfolio will typically price loans lower than their competition, while higher interest rates will apply if they don’t need new loan volume. Consumers seeking equity loans can often find deals that offer prime rate or close to prime rate interest “specials.”

In most cases, however, those borrowers offered loans at the prime rate will be large commercial entities with excellent credit ratings. Although the prime rate is set by financial institutions individually, its use as an “index” of other rates tends to encourage all lenders to set the same annual percentage rate for clarity more than income reasons.

How interest rates are determined

Interest rates, whether those that you are earning (deposit account) or paying (loan), are determined by a number of components. Here are the most important factors for each type of interest rate determination.

Savings and deposit accounts

The most important factor in deposit (e.g. savings account) interest rate determination is the competition. A related component is the institution’s need for deposits. These factors are really intertwined. For example, your bank or credit union wants to increase its deposits. It’s not difficult. They will offer deposit account interest rates higher than much or all of the competition. The money will come in, guaranteed.

If the institution has no specific purpose for more deposits, they will typically offer interest rates equal to the lower options offered by their competition. This reduces their “cost of funds,” which allows them to lower their loan interest rates or generate more profit.

Loans and lines-of-credit

Think of loan interest rate pricing as if you were managing a retail store. Your “selling price” (interest rate) is a combination of a) what you paid for the goods you’re selling (cost of money) and b) what the competition is charging. Loan interest rates are set based on the lender’s cost of the money and the rates their competition is charging.

If your bank or credit union is seeking new loans, they will typically lower their interest rates. Conversely, if they don’t need an increase in new loans, they will increase their rates to be slightly higher than competition. They may not generate many new loans, but they will earn more interest and generate higher profit per loan.

While the actual calculations are much more complicated, you now understand the basic theory used to set both savings and loan rates for every institution.