A Certificate of Deposit, or CD, is a time deposit account with a fixed interest rate and term.
Does that sound like jargon? Here's what it means.
A "time deposit account" is exactly what it sounds like - it's an account in which you deposit money for a specific period of time. That time could be 6 months, 9 months, 1 year, 5 years, or any other predetermined increment of time.
A "fixed interest rate" is an interest rate that's locked in place. The interest rate doesn't change, regardless of what's happening in the broader economy.
A "fixed term" means that the length of time is also predetermined. If you try to withdraw money before that length of time is over, you'll get hit with penalties.
Why should you be penalized for wanting to withdraw your own money? You're getting paid for promising to let someone else hold onto your money for a specific, fixed length of time. If you withdraw money early, you're breaking that promise. That's why the penalty comes into play. (Penalty rates vary from bank to bank and can range from a few month's worth of interest to a hefty flat fee).
Joe Smith has $10,000. He could leave it in his savings account, but that only pays an interest rate of 1 percent. (The benefit is that Joe can withdraw money from his savings account at anytime).
But Joe is sure that he won't need the money for at least one year. He wants to earn more interest, but he doesn't want to risk losing money in the stock market. So he decides to go to his bank and buy a one-year CD at a 2.5 percent interest rate (also called "annual percentage yield," or APY).
This means that if Joe leaves his money in the CD for one year, as he promises, he'll get all his money back PLUS an extra 2.5 percent at the end of the term.
How can you preserve liquidity while investing in CD's? (In other words, how can you access some of your cash while you invest in CD's?)
One popular practice is called "laddering CD's." That means you buy several CD's of different durations. Here's how it works:
Jane Doe has $10,000. She doesn't want to tie up all of her money for a year, like Joe Smith did. Instead, she divides her money across 5 different CD's, each valued at $2,000.
One CD is only has a 3-month duration. One is a 6-month CD. One is a 9-month CD. One lasts for 12 months. And one is a 15-month CD.
At any given point in time, Jane Doe is within three months of being able to access $2,000 penalty-free. If she needs the money to repair her roof or replace a broken dishwasher, she'll simply wait for 3 months for the next CD to expire. Then she'll keep that $2,000. If she doesn't need the money, she'll use the money to buy the 15-month CD (the longest term).
She earns the best interest rate on the longest-term CD, the smallest interest rate on the shortest-term CD, and middle-of-the-road interest rates on the mid-term CDs.
Jane Doe doesn't have as good of an interest rate as Joe Smith, who put his entire $10,000 in a one-year CD. But Jane has more access to her money. She's traded some of her returns for liquidity.
Laddered CD's Are Great for Emergency Funds
Because Jane can access her money so easily (within 3 months), she feels comfortable keeping some of her emergency fund in the form of laddered CD's. She'll be able to pay for car repairs, home repairs and other unplanned events with this money.
Joe Smith, on the other hand, can't keep his emergency fund in CD's because he won't have access to the money for up to a year.