CDs Guide

1. What is a CD?
Remember when your parents offered you cash to do chores or your homework? A certificate of deposit (CD) works the same way-except the bank pays you extra for doing nothing.

Sold by banks, CDs are low-risk - and lowish return -- investments suitable for cash you don't need for months or years. If you leave the money alone during the investment period (known as the "term" or "duration"), the bank will pay you an interest rate that's slightly higher than what you would have earned in a money market or checking account. All gains from CDs are taxable as income, unless they are in a tax-deferred (IRA) OR tax-free (ROTH IRA) account.

A CD also is an ultra-safe investment. Your interest rate is determined ahead of time, and you're guaranteed to get back the amount you deposited plus interest once the CD matures. What's more, if the bank goes belly up, your CD deposit is probably insured by the FDIC for up to $100,000. (Read more about this insurance here. )

CDs come in a range of types, each offering tradeoffs:

• Traditional CD -You receive a fixed interest rate over a specific period of time. When that term ends, you can withdraw your money or roll it into another CD. Withdrawing before maturity can result in a hefty penalty.
• Bump-Up CD -You have an opportunity to swap your CD's interest rate for a higher one if rates on new CDs of similar duration rise during your investment period. Most institutions that offer this type of CD let you bump up once during the term of your CD.
• Liquid CD -You can withdraw part of your deposit without being penalized. However, the interest rate on this CD usually is a little lower than CDs without this feature, but it's still higher than a money market account's rate.
• Zero-coupon CD -You do not receive annual interest payments during the term of deposit. Instead, the payments are re-invested so you earn interest on a higher total deposit. While the interest rate offered is slightly higher than other CDs, you'll owe taxes on the re-invested interest.
• Callable CD -The bank that issued you the CD can call it back after a set period, returning your deposit plus any interest owed. Banks do this when interest rates fall significantly below the rate it gave you. To make this type of CD attractive, banks typically pay a higher interest rate. These are typically offered through brokerages.
• Brokered CD -This is any type of bank CD that's offered by a brokerage. Brokerages have access to thousands of bands' CD offerings, including online banks. You may be charged a fee for the service. You generally receive a higher rate of interest from online and smaller banks because they're competing nationally for depositors' dollars.

2. Should You Invest?
CDs make financial sense for people of all ages who want a low-risk investment to park cash they don't plan to use immediately. Maybe you want to use your cash to buy a car or make a down payment on a house pretty soon.

Since you won't need your cash reserve the day after tomorrow or next week, you'll likely want that cash to earn a better rate of return than your checking account offers-without taking on too much risk. This is when a CD is useful.

Two factors to consider when deciding whether a CD is ideal for you:

• Your time horizon. When will you need part or all of your cash? Do you have other cash resources to turn to in a pinch? For example, if you don't expect to need the cash for six months or longer, a CD may be ideal.
• Interest rates. The anticipated direction of interest rates will help you determine how long to tie up your money. If they're rising (usually when inflation is on the rise), a short-term investment may be best. If rates are falling (usually when the economy is tanking), a longer-term CD may be more beneficial, since you'll lock in a higher rate.

3. How to Invest
Before you shop for a CD, there are two numbers you need to know:

• APR -The annual percentage rate, or the interest rate a bank is offering on the CD.
• APY -The annual percentage yield, which tells you what you'll earn over the multiyear life of the CD as your money "compounds."

Yikes, what's compounding? Put simply, it's how your investment gets bigger and bigger over time. For example, let's say you invest $10,000 in a three-year CD earning 5% annually. In the first year, your $10,000 investment will earn $500. In the second year, 5% of the new total ($10,500) will be $525. In the third year, 5% of $11,025 will be about $551. That's compounding.

Want to see what your APY would be if you invested in a CD? Try our CD Calculator.

Steps to take if a CD is an ideal investment for your cash:

• Choose your term. Determine how long you want to tie up your money. This will depend on when you need it or if you have other cash assets to tide you over until the CD matures.
• Pick your type. Decide which type of CD will be best. For example, if you want to invest for two years and don't want the risk of being stuck with a low rate, then a bump-up CD may be ideal. Afraid you'll need part of your deposit for an emergency? Consider a liquid CD.
• Review the rates. Once you've selected a time period and CD type, find out about rates here .

Consider a ladder
One way to reduce a CD's drawbacks is to use a technique called "laddering." This strategy gives you regular access to part of your cash and protects you against rising interest rates.

Laddering is simple. Instead of investing one big chunk of cash in one CD, you divide your lump sum into equal parts and invest each in CDs of varying durations.

Here's how it works: Let's say you want to invest $15,000. You'd invest $5,000 in a 1-year CD, $5,000 in a 2-year CD and $5,000 in a three-year CD. Then, each time one of the three CDs matures, you'd either take the cash or re-invest it in another three-year CD to keep your ladder in place.

As you can see, laddering provides three cool benefits:

• Penalty-free access to cash each time a CD matures.
• More favorable interest rates, since you're always investing in a longer-term CD.
• A shot at better returns if interest rates are higher when you re-invest.

4. Grilling Guide: Questions to Ask Before You Invest
How long do I want to tie up my cash?
This will depend on when you will likely need it and interest rate trends.

Which CD types are best for me?
Ask yourself if higher rates or access to cash is more important. Then ask banks which CDs are most suitable for your needs.

Which bank has the best rates on the CD I want?
Get a feel for rates here. Then look through our directory to find the best one for you.

What about fees?
While banks do not charge for CDs, ask what you'll be charged if you withdraw your invested assets before the CD matures.

Is the bank insured by the FDIC?
To find out, type in the name of the bank at the FDIC's verification site.

If I ladder, will the cash amounts that come due be sufficient?
Use our CD ladder calculator to determine how much will come due each time one of your CDs matures.