A CD, or certificate of deposit, is a low risk tool for growing your savings. When you buy a CD, you agree to invest your money for a set amount of time. In exchange, the bank guarantees you a set rate of interest. When your CD matures, i.e. reaches the end of the set time period, you receive the money you invested plus any earned interest. While you can withdraw the funds at any time, if you do so prior to the maturity date, you'll likely be subject to an early withdrawal penalty.
CDs can be useful in reaching definitive short-term savings goals, like making a down payment on a home next year, or funding college costs in five years. They generally offer better interest rates than savings accounts while providing safety and reliability not found in other investment vehicles. Because most CD rates are locked in, they are not subject to the ups and downs of the market. Additionally, funds placed in a CD at an FDIC-member bank are insured by the Federal Deposit Insurance Corporation up to the maximum of $250,000.
To maximize growth during the term of a CD, it's important to know the basics of CD rates. Rates will vary depending on the bank and the term of the CD. Before locking into a long-term commitment, rates should be compared and fully understood.
Annual Percentage Rate
The Annual Percentage Rate (APR) on a CD is the percent of your investment that would be earned in interest if you held the investment for a full year. Even if the term of the CD is less than a year, six months for example, the rate of return quoted is still that of the annual return, not the shorter six month time frame.
In addition to the Annual Percentage Rate, how often your money compounds will also determine your total yield upon maturity. The rate of compounding is how often your earned interest rolls over into the balance of your CD. For example, a CD with monthly compounding pays out 1/12th of the year's interest at the end of each month. With that earned interest going directly into the balance of the CD, the earned money earns interest along the way. CDs compound in a variety of ways- monthly, quarter, annually etc., but the more compounding, the better.
Annual Percentage Yield
Rather than figuring out the math of your potential CD returns based on Annual Percentage Rates (APR) and frequency of compounding, you can simply reference the Annual Percentage Yield (APY), which takes into account both of those pieces and provides a comprehensive, standardized number that can be used to easily compare various CDs. When shopping for rates, make sure you're comparing APY to APY rather than APY to APR. By Federal Regulation, all financial institutions must quote APY so that the consumer can compare apples to apples when shopping rates.
While locking into rate with a CD can protect you from potential losses when the market drops, it can also prevent you from benefiting from big gains when the market rises. Before investing in a CD, be sure to not only shop and properly compare rates, but also to understand both the protections and limitations of the investment vehicle itself.