A certificate of deposit (CD) is a special type of savings account offered by many banks and thrifts, that usually carries a higher interest rate than a standard savings account. CDs can be a good option for savers with extra capital that want a safe place to earn a respectable interest rate.

CD Basics

The main difference between a CD and a normal savings account is that CDs have a predetermined duration or maturity date. Money saved in a CD typically cannot be removed from the account before the maturity date without some sort of fee or other penalty being incurred. For this reason, it is important not to commit money to a CD that you may need in the near future, since early withdrawal penalties will likely negate any gains from interest. CDs can be a good place to save money for a few months to a few years because the interest rates they earn are usually higher than normal savings accounts. The longer the duration of the CD, the higher the interest rate is likely to be, which can further increase interest earned. This is an added benefit of CDs over normal savings accounts. If you have some extra capital that you won't need for a long time, choosing a CD that lasts more than a year can significantly increase your savings.

Best Time to Buy

One of the main benefits of CDs is being able to lock in savings at a given interest rate. The best time to buy into a CD is when interest rates are relatively high and likely to fall in the future. For instance, interest rates on CDs were over 5 percent in 2006, which is a good return for a low-risk account that is FDIC insured. By saving in a CD in 2006 that lasted several years, you would have continued earning 5 percent on your money, even though interest rates plummeted in the following years, putting interest rates on normal savings accounts around 1 percent. By locking in your money in a CD, you immunize your savings to changes in the interest rate (note that this applies to fixed rate CDs; some CDs have variable rates that change with changes in interest rates). When interest rates are low, it is not usually considered a good time to buy---while CDs may offer higher rates than normal savings accounts, if interest rates increase your money will be stuck locked in at a low rate. Even variable interest accounts are not likely to capture the full potential of the rising interest rates.

Considerations

If you plan on saving in a CD, make sure you understand all the terms, early withdrawal fees, and that your savings institution is reputable and FDIC insured. If you do happen to have a sudden need to access the money in your CD, it may be possible to sell off your CD to a third party in order to avoid early withdrawal penalties. Withdrawal penalties are the main drawback of CDs versus normal savings accounts, but by selling off CDs in the secondary market, it is possible to avoid or minimize the downside.

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