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How do CDs work, and are they worth it?

Name ____________________ Date __________

Key ideas

  1. A CD trades access for a locked rate. The rate can't drop during the term. In return, taking money out early usually costs a penalty set by the bank.
  2. The penalty can be bigger than your interest. Leah's 5-year CD earned $99 in 6 months, but the 12-month penalty was about $200. She got back $4,899.
  3. Match the term to the date you need it. Money for a goal in 12 months fits a 12-month CD. If the date is fuzzy, keep the money in savings instead.

Vocabulary

Certificate of deposit
A bank deposit that pays a fixed rate for a set term, like 6 months or 5 years, with a penalty if you take the money out early.
Credit union
A not-for-profit financial cooperative owned by its members, offering checking, savings and loans much like a bank.
FDIC insurance
US government protection that repays your deposits if an insured bank fails, up to $250,000 per depositor, per bank, per ownership category.
NCUA insurance
Federal deposit insurance for credit unions, run by the National Credit Union Administration and backed by the full faith and credit of the United States.
APY
Annual percentage yield: the yearly return on savings, including the effect of compounding. Use it to compare savings accounts.
Emergency fund
Cash set aside only for surprises like a job loss, a car repair or a medical bill. A common goal is 3 to 6 months of essential costs.

Work it out

Leah puts $5,000 in a 5-year CD at a 4.00% APY (an example rate). The penalty is 12 months of interest. After 6 months, her car needs a $4,500 repair.

  1. Deposit
  2. Interest earned in 6 months
  3. CD value at 6 months
  4. Penalty, 12 months of interest
  5. Leah gets back
  6. If kept the full 5 years

Check yourself

  1. You have $8,000 and you're sure you'll need it for tuition in 12 months. Which fits best?

    • A. A 5-year CD
    • B. A 12-month CD or high-yield savings
    • C. A stock index fund
    • D. Your checking account

  2. A $10,000 CD has a 3.00% APY and a penalty of 6 months of interest. About how big is the penalty?

    • A. $30
    • B. $150
    • C. $300
    • D. $600

  3. Your CD matured yesterday and renews automatically. What can you usually do now without a penalty?

    • A. Nothing until the next term ends
    • B. Withdraw only the interest
    • C. Withdraw or move the money during the grace period

Your turn

Write down any savings goal with a firm date in the next 6 to 24 months. Then look up the APY and early withdrawal penalty for a CD at your bank and one online bank that matures just before that date.

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Answer key

How do CDs work, and are they worth it?

Work it out

  1. Deposit$5,000
  2. Interest earned in 6 months$99
  3. CD value at 6 months= $5,099
  4. Penalty, 12 months of interest− $200
  5. Leah gets back= $4,899
  6. If kept the full 5 years$6,083
  1. Six months at a 4.00% APY earns $5,000 × (1.04 to the power of 0.5 − 1) = about $99.
  2. A year of interest is $5,000 × 4.00% = $200, so the penalty is about $200. $5,099 − $200 = $4,899, which is $101 less than she put in.
  3. Had she kept it 5 years, it would grow to $5,000 × 1.04 × 1.04 × 1.04 × 1.04 × 1.04 = about $6,083. The lock only pays if you keep it.

Check yourself

  1. B. A 12-month CD or high-yield savings The date is known and short, so a CD that matures on time or a high-yield savings account fits. A 5-year CD would mean a penalty, and stocks can drop right before you need the money.
  2. B. $150 A year of interest is $10,000 × 3.00% = $300. Six months is half of that, $300 ÷ 2 = $150.
  3. C. Withdraw or move the money during the grace period Most auto-renewing CDs have a short grace period after maturity when you can withdraw or move the money with no penalty. After that, the new term is locked.