Fixed-Rate Certificate of Deposit (CD)

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

A fixed-rate certificate of deposit (CD) is an investment instrument that has a set interest rate over its entire term. CDs generally offer terms in increments of three months up to one year and then switch to two-year, three-year, and five-year terms. The longer the term of the fixed-rate CD, the higher the fixed interest rate. Large and small retail banks alike offer fixed-rate CDs.

Understanding a Fixed-Rate CD

Savers who are conservative with their investments are attracted to fixed-rate CDs, which give them known income streams until maturity. Furthermore, because CDs are guaranteed by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 (per account holder, per issuer), investors who place their money in these instruments feel comfortable about the safety of the asset value. Fixed-rate CDs may not pay as much interest as other fixed income securities, but conservative savers accept the trade-off of lower interest for lower capital risk.

There is typically a penalty for early withdrawal of funds from a CD, so a CD holder almost always leaves the money in the instrument until it matures. Upon maturity, depending on the individual’s financial needs, they may roll over the matured CD into another one. The new fixed rate, however, is likely to be different from the one that just matured. The general interest rate environment in the economy determines how fixed-rate CDs are set by issuing banks.

Fixed-Rate CD vs. Variable-Rate CD

A variable-rate CD has a fixed term like the fixed-rate CD, but interest payments can fluctuate, as the CD’s rate is tied to a certain index, such as the prime rate index, consumer price index (CPI), or Treasury bill rate. The amount paid out is based on a percentage difference between the beginning index value and the final index value. An investor in a variable-rate CD is less risk-averse than a fixed-rate CD buyer, and the individual, by putting money into a variable-rate CD, may express their belief that interest rates in the economy will rise over the term of the CD. If that proves correct, the CD will have generated more interest than a fixed-rate CD.

CD holders must pay federal taxes on the interest they earn at their tax bracket rate.

Example of a Fixed-Rate CD

A fixed-rate CD that guarantees interest rate returns of 5% is offered by a bank. The CD’s term period is six months. Tatiana invests $1,000 in the CD. After six months she has the option of withdrawing the $1,050 or rolling it over into another CD. She chooses the latter option and, at the end of a year, withdraws $1,100 upon its maturity. She will owe taxes on her $100 earnings.

Tatiana’s friend Marc has also invested $1,000 in the same CD, but he is forced to withdraw the entire amount after three months due to a family emergency. The penalty for early withdrawal is three months of interest. Marc pays a penalty of $12.50 for early withdrawal.