certificates of deposit: terms, ladders, and early withdrawal penalties

In short

A friend of mine once told me his savings account felt like a leaky bucket, and he wanted something that held still. A certificate of deposit, or CD, is one answer. You lend a bank or credit union your money for a set time, and the institution pays a set rate in return. If you are holding cash you will not touch for a while, a CD can give that money a steady job. The trade is simple: the bank must pay the rate it promised, and the depositor has to leave the money alone or pay a penalty. A ladder spreads your money across several end dates so some of it frees up on a regular schedule. Before you open one, check three things: the term, the rate, and the penalty for pulling out early. Then confirm that the bank carries FDIC insurance, or the credit union carries NCUA insurance, up to the current figure, which the official source publishes each year.

The whole of it

What it is

I once watched my neighbor lock his fence gate every night, though nobody ever came by. He slept better for it. A CD works a bit like that gate. You hand your money to a bank for a fixed stretch, and in exchange the bank locks in a rate for you. The stretch is called the term. Terms run from a few months to several years.

Here is the plain part. A regular savings account lets the bank change its rate whenever it likes. A CD does not. The bank must pay the rate it printed on the day you opened the account, right through the term. That is the whole appeal. You know what you will earn before you start.

The other side of the bargain is access. The bank gets to use your money for the full term. So the depositor agrees to leave it there. If the money comes out early, the bank charges a penalty. We will get to that.

One more piece. When the term ends, the CD matures. That word just means the date arrives and the money is yours again. The bank usually gives a short grace period to act. If the depositor does nothing, many banks roll the money into a new CD at whatever rate is current. Read your agreement so that surprise does not catch you.

How it works

A friend of mine opened a CD at her credit union and called me, a little nervous about the paperwork. It turned out to be easy. You choose an amount, pick a term, and fund the account. The bank states a rate and an annual percentage yield, or APY. The APY is the yearly return after counting interest on interest, so it lets you compare one CD against another fairly.

Interest builds up on a schedule the bank sets. Some pay it monthly. Some add it to the balance. Some hold it until maturity. The account agreement says which. That choice matters if you want income along the way.

Now for the ladder. If you have ever stacked firewood by size so the next piece is always easy to grab, you already understand it. A ladder splits your money across CDs with different end dates. Say you have $10,000. You might put $2,500 each into a one year, two year, three year, and four year CD. Each year, one of them matures. You can spend that money or roll it into a new four year CD. After a while, you hold a four year rate on every rung, and cash comes free every twelve months.

Why bother? A ladder softens two worries. One is needing cash at a bad moment. The other is locking everything in before rates rise. With a ladder, you are never all in and never all out.

The numbers, and where to find yours

Your own situation comes first here. You have probably wondered what number to check before you sign. There are four.

The first is the rate and APY. The bank posts both on its site and in your account agreement. Compare APY to APY, not rate to rate.

The second is the term. It is stated in months or years on your agreement.

The third is the early withdrawal penalty. Banks set their own. Many state it as a number of months of interest, such as 90 days of interest on a one year CD. It is written in your account disclosure, which the bank must give you before you open the account. Ask for it.

The fourth is the insurance limit. Deposits at an FDIC insured bank are covered up to the current figure, which the official source publishes each year per depositor, per bank, per ownership category. The FDIC explains this on its own site, including a tool called EDIE that lets you test your coverage. Credit unions carry similar coverage through the NCUA, and its site has a share insurance estimator. Both agencies are the primary sources for these rules.

Where do you find a current CD rate? Every bank posts its own. Compare a few. The rates move, so I will not quote one here.

A worked example

Let me tell you about a woman named Marjorie. She is a retired schoolteacher with $20,000 set aside for a roof repair she expects in about three years. She does not want it in the stock market. She wants it safe and earning something.

Marjorie builds a small ladder. She splits her money into four equal parts. $20,000 divided by 4 is $5,000 per rung. She opens a one year, a two year, a three year, and a four year CD at $5,000 each.

To keep the math easy, suppose each CD pays a plain 4 percent a year, with interest paid out rather than compounded. These rates are made up for the example, not a quote. The one year CD earns $5,000 times 0.04, which is $200 a year. The same $200 comes from each rung each year, so the four together earn $800 a year. Over one year, that is $800 on $20,000.

At the end of year one, her first rung matures. She gets $5,000 back plus $200. She has the roof in mind, so she keeps that cash in a savings account. By year three, her three year CD matures too. She now holds cash from two rungs, about $10,000, plus the interest, ready for the roofer.

Now picture the penalty. Suppose Marjorie breaks her four year CD after two years, and the penalty is 180 days of interest. A 4 percent rate on $5,000 is $200 a year. Half a year of that is $100. So she would forfeit about $100. If the bank takes more than she has earned so far, it can dip into her original deposit. That is why you read the penalty first.

She chose the ladder so she would not have to break anything. It worked.

Where it goes wrong

I have made my share of mistakes with money, and most came from skipping the fine print. So let me save you some grief.

The first trap is the penalty. People open a CD and then need the cash. The bank is entitled to charge what the agreement says. It can be steep on longer terms. Only put in money you can truly spare.

The second trap is the auto renewal. The bank may roll your matured CD into a new term on its own. If you miss the grace period, you are locked in again, perhaps at a lower rate. Mark the maturity date on a calendar.

The third trap is inflation. If prices climb faster than your rate, your money buys less, even while the balance grows. A CD protects the dollars, not what they buy.

The fourth trap is going over the insurance limit. If one bank holds more than the current figure, which the official source publishes each year of yours in one ownership category, the extra is not covered. Spread the money out or check the FDIC and NCUA tools.

The fifth trap is taxes. Interest from a CD counts as income. The bank reports it, and it is taxed in the year it is credited, even if you have not withdrawn it. Keep that in mind.

Last, a callable CD. Some banks reserve the right to end the CD early, which is called a call. If rates fall, they may hand your money back and you lose the higher rate. Ask whether a CD is callable. That is a fair question.

Questions to answer before you leave this page

When will you need this money, and is it a date you can trust? If the answer is soon, would a shorter term or a savings account suit you better? What is the early withdrawal penalty in the agreement, and could you live with it if life surprised you? Does the APY on this CD beat the others you looked at, and did you compare APY to APY? Is the bank covered by the FDIC, or the credit union by the NCUA, and does your total at that institution stay under the current figure, which the official source publishes each year? Is the CD callable, and does it renew on its own at maturity? Would a ladder, with money coming due on a schedule, fit your plans better than one big lump? And have you marked the maturity date where you will see it?