What is a certificate of deposit & how does it work?

With interest rates and stock market volatility on the rise, you might be trying to determine the best way to save for your goals. Certificates of deposit (CDs) can provide an attractive alternative when compared to traditional savings accounts and stock investments. But how does a certificate of deposit work, what are they used for and how do you buy them?

Learn more about CDs, including the pros and cons and how to find the right CD for your personal savings goals, here.

A certificate of deposit is a type of account that pays a fixed interest rate over a fixed time period. Since CDs pay higher interest than most traditional savings accounts and are Federal Deposit Insurance Corporation (FDIC)-insured up to $250,000 or  National Credit Union Administration (NCUA) insured, they can be a relatively safe way of growing your savings.

A CD has two main components: the interest rate and the fixed length of time (or term) for that interest rate. The longer the term, the higher the interest rate you generally can receive. Terms may be set in increments of months, such as six months, 12 months, 18 months, 24 months or 36 months. The longest term is typically 60 months or five years.

The reason banks offer higher interest rates on CDs compared to traditional savings accounts is because you're allowing them to hold the money for an extended period of time. This is attractive to the bank because it can use that money by lending it out to other clients.

At the end of the term, which is also called the maturity date, you can choose to renew your CD for another term, usually at a new interest rate, or redeem your CD and use the cash in another way.

CDs can be used for a variety of purposes, but the primary purpose of a CD is to earn higher interest than other accounts for a specified period of time. For example, if you want to save a lump sum for a planned event, such as a wedding or a big vacation, and it's a little more than a year from now, you might choose a 12-month CD to earn more interest than you would in your savings account.

A CD also can be used as an alternative or a supplement to a long-term savings goal. For example, if you want to save money for retirement but you don't want it exposed to the stock market, a CD can be a safe alternative. Although a CD generally earns lower average rates of return than stocks over time, it can't suddenly decline in value at a time when you may need the money most.

CDs are often referred to as "safe," but how safe are they? CDs offer a fixed interest rate, and they're insured by the FDIC for up to $250,000 per individual per bank. For example, if you have a $250,000 CD, and your bank forecloses, the FDIC insures the funds in your account and pays you if your bank fails.

CDs and savings accounts are both types of interest-bearing accounts. However, there are a few key differences, such as interest rates and withdrawal options, that are important to understand before choosing one over the other.

The main differences between CDs and savings accounts are:

• Interest rates. CDs generally pay higher interest rates than savings accounts. To get the higher rate for a CD, you agree to allow the bank to hold it for a specified period of time, such as six months, a year or longer.
• Withdrawal options and penalty. If you withdraw before the end of the CD's term, you may have to pay a penalty, which is often equal to the interest you've already been paid. However, with a savings account, you can withdraw at any time without penalty.

Interest rates on CDs can be influenced by multiple factors. While banks determine the interest rates on CDs they offer, they generally set their CD rates according to the prevailing interest rate, called the federal funds rate, which is set by the Federal Reserve.

The federal funds rate is influenced by economic conditions. When the economy is weak or in recession, the Federal Reserve may lower interest rates to encourage borrowing, which can stimulate the economy. But if the economy is growing too fast, the Federal Reserve may raise its federal fund rate to discourage borrowing, which can slow the economy and help fight inflation.

Competition among banks, credit unions and other financial institutions also may influence the interest rate paid on their CDs.  Thrivent Credit Union offers competitive CD rates to grow your savings risk free.

CDs are taxed like other accounts and securities that pay interest, which means you pay income tax on the interest you earn on the CD. The interest is taxable in the year it's paid, and if you've earned more than $10 in interest that year, the issuing bank typically provides you with a 1099-INT statement.

Some financial institutions offer a CD individual retirement account (IRA), which is a tax-advantaged retirement account that holds a certificate of deposit. Interest earned in an IRA isn't taxed while it's held in the IRA.

The timing for opening a CD generally depends on your personal savings goals, but you also may choose your timing based on current interest rates. For example, if you're saving for a specific goal that's several months or a few years from now and you want to get an interest rate higher than most savings accounts, it could be a good time to open a CD. It also may be a good time if you have excess cash sitting in a savings or money market account earning at a lower rate. Putting that money to work for a short period of time in a certificate can allow for greater earnings while the funds are not being used.

If getting a high interest rate is your priority, a good time to open a CD is when prevailing rates are higher. One of the fortunate results of the recent increase in interest rates is that CD rates are higher now than in the recent past. If you think rates may continue to rise in the near future, you may want to wait to open a CD. But if you think rates may fall in the near future, opening a CD now can be a good idea.

When a CD matures, it means the predetermined period of time to hold the CD has ended. At maturity, you can make one of a few basic choices: You can renew the CD, start a new term and possibly get a new interest rate, or withdraw the principal amount and use the cash as you see fit.

While CDs offer multiple advantages, they're not ideal for everyone. Therefore, it's important to understand the certificate of deposit benefits and risks before holding your money in one.

• High interest rate. CDs generally pay higher interest rates than savings accounts.
• Safety. The issuing bank determines the set amount of interest the CD earns, and deposit amounts are FDIC-insured up to $250,000.
• Flexible terms. Although CDs require you to keep your money on deposit for a fixed period of time, you get to choose the term, which typically ranges from six months up to five years.

• Withdrawal restrictions and penalty. If you withdraw a CD before the maturity date, you may owe a penalty, which is typically equal to the amount of interest you've earned thus far.
• Inflation risk. The interest CDs pay tends to lag behind inflation and the prevailing interest rates set by the Federal Reserve. Therefore, the interest rate paid on a CD today could be lower than today's rate of inflation, and that interest rate also could be lower than CD rates paid in the future.

You typically can open a CD at a bank, credit union or other financial institution. Since rates and terms may vary by the bank, it's wise to shop around to find a competitive rate. You also need to find out if the bank requires a minimum opening balance for a CD. Sometimes, higher balances can receive higher interest rates.

The final decision about choosing the right CD for you is the term, which is the amount of time you need to hold the CD at the bank before it matures. The term of your CD should closely match the time horizon of your savings goal. For example, if you're saving for a goal that's 15 months away from now, you may want to choose a 12-month term, rather than an 18-month term, so you can avoid any penalties for withdrawing before maturity.

Before putting your money to work in a CD, you have many factors to consider, including the interest rate, the terms available and the prevailing economic conditions that may impact the direction of interest rates.

Reach out to Thrivent Credit Union to find the right CD for you and plan how this account can fit into your larger financial picture.