What is a Certificate of Deposit, and should you lock your money in one?

What is a certificate of deposit?

A Certificate of Deposit (CD) is a specific type of savings account offered by banks and credit unions. To open a CD account, a customer deposits a lump sum of money for a fixed period, known as the “term.” This term can range from just a few months to five years or more.

CDs can be issued by banks or credit unions, which makes the creditworthiness of the issuer an important consideration. They're essentially debt securities: you're lending money to the institution, and in return, it is obligated to repay your principal plus the agreed-upon interest at the end of the term. The interest rate is usually fixed and often higher than the rates offered on traditional savings or money market accounts 1.

This fixed rate is guaranteed for the duration of the term, so you know exactly how much interest you will earn when the CD matures. At maturity, CD holders are entitled to receive both the principal and the accrued interest.

Additionally, CDs can be denominated in different currencies, which means currency risk may apply for foreign currency CDs. Deposit protection may or may not be available, depending on the jurisdiction. In Hong Kong, CDs aren't covered by the Deposit Protection Scheme as they're not considered equivalent to time deposits.

How certificates of deposit work

The process of investing in and managing a Certificate of Deposit is simple and follows a clear lifecycle. Understanding these steps is key to leveraging CDs effectively for your financial goals.

1. Opening the CD: The first step is to choose a financial institution and a CD that aligns with your needs. You’ll need to consider the interest rate, the term length, and the minimum deposit required. Before you subscribe to a CD by depositing your principal amount into the account, it is important to carefully review the details of the CD, including features, risk disclosures, and terms. All relevant terms and risks should be disclosed to you by the institution before you subscribe.
2. The Holding Period (Term): Once your money is deposited, it is locked in for the agreed-upon term. During this period, your investment earns interest. Most CDs compound interest, meaning the interest you earn is added to your principal, and future interest calculations are based on this new, larger amount. Interest can compound daily, monthly, or quarterly, depending on the institution’s policy 4.
3. Maturity Date: The end of the term is called the maturity date. On this day, your CD has fully matured, and you have access to your original principal plus all the interest it has accrued.
4. Post-Maturity Options: When your CD matures, you typically have a “grace period” (usually 7-10 days) to decide what to do with the funds. Your options generally include 2,5:
   
   • Withdraw the funds: You can cash out the principal and interest without any penalty.
   • Renew or “roll over”: You can reinvest the entire amount into a new CD of the same term length. If you choose this, you'll receive the current interest rate offered at the time of renewal, which may be higher or lower than your original rate. Many banks will automatically renew your CD if you don’t provide other instructions during the grace period. You also have the option to re-invest your funds in a different CD or another investment product.
   • Reinvest in a different CD: You might choose a different term length or type of CD based on current rates and your financial situation.
   • Sale of brokered CDs: If you hold a brokered CD, you may have the option to sell it on the secondary market before maturity. The market price of the CD at the time of sale may differ from your original purchase price, depending on prevailing market conditions.

A critical feature to understand is the early withdrawal penalty. If you need to access your funds before the CD’s maturity date, you will almost always have to pay a penalty. This penalty is typically equivalent to a certain number of months’ worth of interest and can, in some cases, even eat into your original principal, as the penalty amount is deducted from the interest or principal 3.

Types of certificates of deposit

Consumers can consult a list of available CD types or rates to easily compare options and find the best fit for their needs.

While the traditional CD is the most common, financial institutions have developed several variations to meet different investor needs. Here are some of the most prominent types:

Traditional CD

This is the standard, most common type of CD. It offers a fixed interest rate for a fixed term. Its simplicity and predictability make it a popular choice 6.

Jumbo CD

Functionally similar to a traditional CD, a jumbo CD requires a much higher minimum deposit, typically USD $100,000 or more. In exchange for this larger deposit, banks often offer a slightly higher interest rate 6.

No-Penalty CD (Liquid CD)

This type of CD offers a solution to the liquidity risk of traditional CDs. It allows you to withdraw your funds before the maturity date without incurring an early withdrawal penalty. The trade-off is that no-penalty CDs usually offer lower interest rates than their traditional counterparts with similar terms 8.

Step-Up CD

A step-up CD comes with a pre-scheduled series of interest rate increases during its term. For example, a 3-year step-up CD might have its rate increase once every year. This can be an attractive option in a rising interest rate environment 7.

Bump-Up CD

Similar to a step-up CD, a bump-up CD allows you to take advantage of rising rates. However, instead of automatic increases, it gives you the option (usually once or twice during the term) to "bump up" your current rate to the bank's new, higher rate for CDs of the same term length 7.

Indexed CD (Market-Linked CD)

This is a more complex product where the interest earnings are tied to the performance of a market index, such as the S&P 500. While the principal is typically protected, the return is variable. It offers the potential for much higher returns than a traditional CD but also carries the risk of earning no interest if the linked index performs poorly. The return on an indexed CD depends on the future performance of the linked index 6.

Brokered CD

These are CDs that you purchase through a brokerage firm rather than directly from a bank, and investors can transact brokered CDs through brokerage platforms. Brokered CDs can be traded on a secondary market, which provides a way to access your money before maturity without an early withdrawal penalty. However, the price you get on the secondary market can fluctuate, meaning you could sell it for more or less than your initial investment. Brokered CDs are part of the investment services offered by financial institutions 5.

Benefits of certificates of deposit

CDs remain a cornerstone of conservative investment strategies for several compelling reasons.

Including CDs in your investment portfolio can provide stability and predictable returns, making them an attractive option for risk-averse investors.

If you use a CD laddering strategy, you can continue to roll over each matured CD into a new one, helping to maintain your ladder and maximise returns over time 13.

Safety and security

This is the primary benefit. CDs are considered very low-risk. In most countries, they're covered by a national deposit insurance program. For instance, in Taiwan, the Central Deposit Insurance Corporation (CDIC) insures deposits up to NT$3 million per depositor at each member financial institution. Meanwhile, in the US, the Federal Deposit Insurance Corporation (FDIC) insures up to USD $250,000 per depositor per bank. This insurance means that even if the bank fails, your principal is protected up to the coverage limit.

However, CDs don't provide absolute assurance of returns beyond the insured coverage limit. Any representation of safety or guarantees is subject to the terms and conditions set by the issuing institution. Additionally, CDs may not be covered by the protection scheme in Hong Kong or similar deposit protection schemes in other regions, so it's important to check the specific coverage before investing 9,10,11.

Predictable and guaranteed returns

The fixed interest rate provides certainty. The fixed return and terms of CDs should be clearly explained to investors before purchase, ensuring they understand the product features and any associated risks. You know precisely what your return on investment will be when the CD matures, which makes financial planning for specific goals much easier. This predictability is a welcome contrast to the volatility of the stock market 6.

Higher interest rates than savings accounts

CDs consistently offer higher Annual Percentage Yields (APYs) than traditional checking or savings accounts. This allows your money to grow more effectively and provides a better defence against inflation 14.

Wide variety of terms

The flexibility to choose terms ranging from a few months to several years allows you to align your CD investments with specific timelines for your financial goals, whether it’s saving for a down payment on a house, a car, or a future business expense. Opting for a longer-term CD can be especially beneficial if you expect interest rates to decline or want to lock in current higher rates for an extended period 6.

Promotes disciplined savings

The early withdrawal penalty, while a risk, also serves as a strong psychological deterrent against impulse spending. By giving up immediate access to your funds, you can benefit from higher interest rates offered by CDs. It encourages you to leave your savings untouched and let them grow as planned 3.

Risks associated with certificates of deposit

Investment involves risks, and customers should carefully consider all factors before making an investment decision. Investment decisions should be based on a thorough understanding of the risks, as outlined in the relevant offering documents.

The services mentioned in this article, including CDs and related services, may not be suitable for all customers. Therefore, you should seek independent professional advice as well as review all relevant risk disclosures and notices before investing.

The accuracy or completeness of information provided is important, and customers should verify all details before proceeding. The suitability of CDs depends on individual circumstances, including investment experience, risk appetite, and financial goals.

The value of CDs may depend on the creditworthiness of the issuer and, for foreign currency CDs, may be affected by exchange rate fluctuations. In a worst-case scenario, such as issuer default, customers could experience a loss of principal. Investment decisions should be made in light of the customer's personal situation and objectives.

Despite their reputation for safety, CDs aren't entirely without risk. It’s crucial to be aware of these potential downsides before investing.

Liquidity risk

Your money is not easily accessible. If an emergency arises and you need to withdraw your funds before the maturity date, you will face a penalty that reduces your earnings 1.

Interest rate risk

When you lock in a fixed rate, you risk missing out if market interest rates rise during your term. For example, if you invest in a 5-year CD at 3% and rates for new 5-year CDs jump to 5% a year later, you are stuck earning the lower rate for the next four years. This represents a significant opportunity cost.

The Federal Reserve's monetary policy works by influencing the overall level of interest rates in the economy, which directly affects the rates banks offer on new CDs 12.

Inflation risk

This is perhaps the most significant risk for any fixed-income investment. If the rate of inflation is higher than the interest rate on your CD, your investment is actually losing purchasing power over time. Your money is growing, but its real value is shrinking.

Reinvestment risk

When your CD matures, there's no guarantee that you'll be able to find a new CD with a comparable interest rate. If market rates have fallen, you'll have to reinvest your funds at a lower yield, reducing your future earnings.

Credit risk

While minimal for insured deposits, this risk exists if your deposit exceeds the insurance limit or if you invest in a CD from a non-insured institution. It is the risk that the issuing bank could default on its obligation to repay your principal and interest 15.

How to mitigate the risks

Smart strategies can help you enjoy the benefits of CDs while minimising their inherent risks.

1. Build a CD Ladder: This is the most popular strategy for mitigating both interest rate and liquidity risks. Instead of putting all your money into a single CD, you divide it and invest in multiple CDs with staggered maturity dates. For example, with HK$25,000, you could invest HK$5,000 each into 1-year, 2-year, 3-year, 4-year, and 5-year CDs 13.
   
   • This enhances liquidity: A portion of your money becomes available every year.
   • This reduces interest rate risk: As each CD matures, you can reinvest the proceeds into a new 5-year CD at the current (and hopefully higher) market rate. This allows you to average your returns over time.‍
2. Create an Emergency Fund First: Before locking money into a CD, ensure you have a separate, liquid emergency fund in a high-yield savings account. This fund should cover 3-6 months of living expenses and will be your first line of defence against unexpected financial needs, preventing you from having to break a CD early.‍
3. Stay Within Insurance Limits: Mitigate credit risk by ensuring your total deposits at any single financial institution do not exceed the limit set by your country's deposit insurance corporation (e.g., NT$3 million under Taiwan's CDIC) 9.‍
4. Choose Shorter Terms in a Rising-Rate Environment: If you expect interest rates or inflation to rise, consider sticking to shorter-term CDs. This allows you to reinvest your money more frequently to capture higher rates sooner.

Should your business lock money in CDs?

For businesses, the decision to use CDs is a matter of balancing security with operational flexibility. CDs can be a valuable tool for corporate cash management, but they aren't suitable for all types of funds.

When CDs Make Sense for a Business:

• Earmarked Funds: If a business is saving for a specific, planned future expense—such as a tax payment, a down payment on new property, or the purchase of major equipment—a CD is an excellent choice. The maturity date can be aligned with the expected payment date, ensuring the funds are safe and earning a predictable return.
• Tiered Cash Reserves: Businesses can use CDs for their "second-tier" cash reserves. While primary working capital needs to remain liquid in a business checking or savings account, excess cash that is not needed for immediate operations can be placed in a CD ladder to earn a better yield.

When to Be Cautious:

• Operational Cash Flow: It is generally unwise to lock up a business's primary working capital in a CD. The need for cash to cover payroll, inventory, and unexpected expenses is paramount, and the penalties for early withdrawal are too steep.
• Opportunity Cost: For a growing business, the return on a CD may be significantly lower than the potential return from reinvesting that cash back into the business through marketing, product development, or expansion. The leadership team must weigh the guaranteed but modest return of a CD against these higher-potential, higher-risk opportunities.

In short, CDs can be a prudent choice for a business's idle or sinking funds, but should not compromise the liquidity required for daily operations and strategic growth.

Unlock greater financial flexibility with Aspire

Certificates of Deposit offer undeniable security and predictability, making them a valuable component of a conservative cash management strategy.

However, for modern, dynamic businesses, the rigidity and lack of liquidity inherent in CDs can be a significant drawback. In today's fast-paced market, financial agility is key, and having immediate access to your capital can mean the difference between seizing a critical opportunity and watching it pass by. That’s why, before locking money into CDs, it’s important to have effective cash flow management in place.

This is where Aspire can help. With Aspire's Business Account, you can track and monitor receivables in real time, giving you clear visibility into your current and upcoming cash inflows. You can also set budgets at the client, team, or project level and track expenses in real time, ensuring you always stay in control of your outflows.

Aspire is more than just a virtual business account—it’s a complete finance solution designed to help you reduce costs. With Corporate Cards offering 1% cashback on SaaS and digital marketing spend, along with transparent, low-cost FX fees for international payments, Aspire helps you manage your money with flexibility and confidence.