What Is a Fixed-Rate Certificate of Deposit (CD) and How Does It Work?

A fixed-rate certificate of deposit (CD) is a form of savings account that locks in your money for a specified period at a fixed interest rate. When a CD matures, holders can withdraw the entire amount or roll it over into another CD.

What Is a Fixed-Rate Certificate of Deposit (CD)?

A fixed-rate certificate of deposit (CD) is a form of savings account that pays a fixed interest rate for the duration of its term. CDs typically offer maturities ranging from three months to one year, after which they transition to two-, three-, and five-year terms in which your money remains untouched in the account. There are also 10-year CDs available.

Although there are exceptions, the longer the duration of the fixed-rate CD, the greater the fixed interest rate. CDs can be purchased online or in person at a bank or credit union.

The Key Takeaways

A fixed-rate certificate of deposit (CD) is a form of savings account that locks in your money for a specified period at a fixed interest rate.

When a CD matures, holders can withdraw the entire amount or roll it over into another CD.

Unless the financial institution offers a promotional rate for shorter terms, longer-term fixed-rate CDs typically pay greater interest rates.

If you take money out of a fixed-rate CD early, you’ll probably have to pay a penalty of several months’ interest.

Understanding a Fixed-Rate CD

Fixed-rate CDs may appeal to cautious investors because they provide consistent income streams until maturity. Furthermore, because CDs are insured by the Federal Deposit Insurance Corp. (FDIC) for up to $250,000 (per account holder, per issuer), investors who invest in CDs have peace of mind about the protection of their assets.

Fixed-rate CDs may not pay as much interest as other fixed-income products, but conservative savers are willing to accept lesser interest in exchange for lower risk.

However, as with any interest-earning investment, investors face the danger of inflation. This happens when the inflation rate surpasses the interest rate on your investment, eroding your future purchasing power.

You can select from a variety of terms for your CD, which commonly vary from one month to several years. During this period, you keep your money in the CD account until the maturity date, or until the term expires. At maturity, you can either withdraw your original deposit plus interest profits or roll the amount and interest into a new CD.

Banks frequently charge a penalty for withdrawing funds from a CD early, so it’s usually advisable to leave the money in the instrument until it matures.

You can roll over the matured CD into another one based on your financial demands. However, the new fixed rate for the CD will most likely differ from the CD that has recently matured.

Fixed-Rate CD vs. Variable-Rate CD

A variable-rate CD, like a fixed-rate CD, has a fixed term, but the interest rate on the CD can change. Some CDs may have one or two rate increase possibilities during the term, which is often longer and has fewer options than a fixed-rate CD. “Bank Products: Types.” Financial Industry Regulatory Authority.

For example, you may be limited to a two- or four-year term and have the opportunity to change your interest rate only once. These CDs may be referred to as rate bump CDs, bump-up CDs, or another title that is exclusive to the bank or credit union. Other variable CDs are linked to an index, such as the prime rate.

A variable-rate CD buyer is less risk-averse than a fixed-rate CD customer and may expect that interest rates will rise during the term of the CD. If the assumption is right, the CD will yield more interest than a fixed-rate CD.

Fixed-Rate CDs vs. Money Market Funds

Fixed-rate CDs and money market accounts are both popular savings vehicles, each with its own set of features, perks, and flexibility. However, their functions are rather distinct. Fixed-rate CDs have a fixed interest rate that stays the same during the term, whereas money market accounts have variable interest rates that fluctuate depending on market circumstances.

Fixed-rate CDs have fixed durations ranging from a few months to several years, whereas money market accounts provide more flexibility in terms of fund access. Investors can frequently deposit and withdraw cash many times in a single month, while there may be restrictions on how many times a saver can engage with money market funds in a short time.

Money market accounts are intended for consumers seeking a balance of liquidity and greater interest rates than normal savings accounts and are appropriate for emergency money or short-term savings goals. In some situations, fixed-rate CDs cannot be broken, which means that savers may have money set up that they won’t be able to access until the term is over.

Minimum deposits for fixed-rate CDs vary depending on the financial institution and the period of the CD. Money market accounts may have a minimum deposit requirement, but it is typically lower than that of fixed-rate CDs.

Account activity for fixed-rate CDs is modest until the account matures, with only interest and not much else gained. Meanwhile, money market accounts may offer some additional functionality. Some accounts, for example, may have check-writing privileges and access to automated teller machines (ATMs).

Advantages and Disadvantages of Fixed-Rate CDs

Pros of Fixed-Rate CDs

Cons of Fixed-Rate CDs

1. Pros of Fixed-Rate CDs

Fixed-rate CDs provide security and assured returns since the bank or credit union agrees to pay the headline—or gross—interest rate over the term of the CD. The rate remains constant independent of economic or financial market swings. This is especially advantageous for risk-averse individuals or those who seek stability in their financial planning (for example, retirees who rely on precise amounts of cash flow becoming available at specific dates).

Fixed-rate CDs are low-risk investments that, as previously stated, are protected by FDIC insurance up to a specified level. This insurance protects primary investments and interest profits from the danger of bank failure, enabling recovery even if the bank is in financial trouble.

Fixed-rate CDs provide stability and predictability, allowing for accurate future value computation, and making it easier to establish financial goals and align savings plans accordingly. They are not affected by market movements or economic situations, which makes them appealing during times of economic uncertainty or market downturns. In some circumstances, investors may consider hedging risky equities investments with fixed-income assets such as fixed-rate CDs to diversify their overall portfolio risk.

Finally, because they are time-bound investments that commit to keeping money invested for a particular term, fixed-rate CDs discourage spending. This inhibits impulsive spending while encouraging careful saving. This assists those working toward long-term financial objectives who may need a little help committing to longer-term savings.

2. Cons of Fixed-Rate CDs

Fixed-rate CDs provide stability and security but at a cost. Fixed-rate CDs often offer lower returns than volatile investments such as equities or mutual funds. Keep in mind that shares may incur losses as well as potentially bigger gains.

These CDs are intended to be low-risk and provide a guaranteed return, but investors may fail to keep up with inflation, resulting in a loss of purchasing power over time. This is especially true when inflation rises rapidly over a short period of time.

Fixed-rate CDs are not liquid assets either. This means that they are not easily accessible before the maturity date of the CD. If you need to withdraw money before the CD expires, you will be penalized and will lose a percentage of the income collected, which can be a substantial disadvantage if you have unforeseen bills or a financial emergency.

Pros

A bank offers a fixed-rate CD with a 5% interest rate guarantee. The term of the CD is six months. Tatiana puts $1,000 into the CD. She has made approximately $25 after six months (the actual amount depends on how frequently the interest is compounded). She has the option of withdrawing the $1,025 or rolling it over into another CD. She selects the latter option and withdraws approximately $1,050 at the end of the year. She will have to pay taxes on her $50 earnings.

Tatiana’s friend Marc, on the other hand, invested $1,000 in a variable or bumped-up 24-month CD. If interest rates grow to 6% or more in the next 12 months, Marc will earn somewhat more than Tatiana by the end of the first year.

Should I Put My Money in a CD During a Recession?

The majority of CDs have a fixed interest rate, but there are variable-rate CDs available that could help you earn a bigger return if interest rates climb. You’ll know exactly how much you’ll earn at the end of the term with a fixed-rate CD, but it could cost you if interest rates climb after you’ve locked in.

2. The term:

This is the amount of time you agree to leave your funds placed to avoid penalties (for example, 6-month CDs, 1-year CDs, 18-month CDs, and so on). The period ends on the maturity date, when your CD has fully matured and you are free to withdraw your funds.

3. The principal:

Except for a few specialized CDs, this is the amount you agree to deposit when you open the CD.

4. The institution:

Early withdrawal penalties (EWPs) and whether your CD will be automatically reinvested if you do not provide any instructions at the time of maturity will be determined by the bank or credit union where you open your CD.

Once your CD is established and funded, the bank or credit union will manage it similarly to most other deposit accounts, with monthly or quarterly statement periods, paper or electronic statements, and usually monthly or quarterly interest payments deposited to your CD balance, where it will compound.

Why Would I Open a CD?

Unlike most other investments, CDs provide stable, safe, and often federally insured interest rates that are frequently higher than those offered by many bank accounts. Furthermore, CD rates are often greater if you are willing to put your money down for extended periods.

CDs have become a more appealing option for savers who wish to earn more than most savings, checking, or money market accounts offer while avoiding market risk or volatility.

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