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Explaining CDs: How They Work and How to Use Them

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CDs: How do they work?

One of the most important money lessons we learn growing up is how to save it. There are a variety of banking products that you can use to help do just that. Certificates of deposit, or CDs, are among the most secure ways to stash your cash.

If you haven’t heard of a CD, it’s a savings account that holds your money for a certain set amount of time. Withdrawing your money before that term ends generally means you’ll incur a penalty charge. In return for leaving your funds untouched for the agreed length of time, you typically earn more interest than you would from a regular savings account.

Although it’s not as flexible as a regular savings account, putting part of your money on hold this way can be productive. Here are a few scenarios where a CD makes sense.

Adding to your future cash flow

If you want to stop yourself from dipping into your savings, figure out how much money you can put away and won’t miss for at least a few months. Since CDs have various terms, typically from three months to five years, choose one that makes sense for you. Keep in mind that longer-term certificates often offer better interest rates, so you may earn more the longer you wait. Most banks characterize CDs in terms of annual percentage yield, which depends partly on how often interest is paid on the deposit.

After the CD’s term ends, you’ll get the cash back along with the interest it has earned, increasing your cash flow. You may want to keep some of it for a rainy day fund in case of emergencies. Lenders like AbbyBank can help you figure out the best way to go when it comes to CDs.

Investing for a later purchase

Opening a CD can help you plan for a purchase you’re not yet ready to make, like a down payment on a car that you want to buy next year. Using a CD can ensure that you’ll have the cash needed when the time comes, with some extra gained along the way from interest earned.

Keeping money safe

If you are afraid of theft or other sorts of losses, a CD is one way to protect your cash. Money held this way is protected by the Federal Deposit Insurance Corp. for up to $250,000, subject to certain limits. So if the bank that holds your CDs fails, you’re still likely to get your money back.

Earning a return

There are ways to use CDs to maximize the interest you earn in a market where rates are near historic lows but are expected to climb. One way is through CD ladders. This involves investing in several CDs with different maturities—for example, one for one year, another for two years and a third for three years. When the first CD matures, you roll the money and earned interest into a new three-year CD. When the two-year CD matures, you do the same with that money. After repeating the process with each maturing certificate, you’ll have a CD with a three-year rate maturing annually.

A CD is a useful banking tool that allows you to set money aside and let it grow over a number of months or years.

To find out if a CD or other savings options are best for your financial goals, AbbyBank’s free calculators can help you decide.

Spencer Tierney, NerdWallet

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