How Do CD Interest Rates Work?
CDs, or certificates of deposit, are bank accounts that require you to keep the money in the account until the maturity date. If you withdraw the money early you will have to pay a significant fee.
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Interest Rates
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Interest rates on CDs are usually higher than other bank accounts, such as savings accounts, because the bank is guaranteed to have your money for a fixed period of time. This allows the institution to make longer-term investments that give a higher rate of return.
Considerations
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The rate of return usually is higher by putting in more money and for a longer time. For example, a five year, $10,000 CD will generally pay a higher interest rate than a six month, $1,000 CD.
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Paying Interest
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Some CDs automatically roll the interest back into the CD so that it will keep compounding and your future interest payments will be larger. However, if you are using a CD as a fixed income tool, you can invest in a CD that pays out the interest each month.
Benefits
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CDs usually have a fixed interest rate over their lifespan, unlike other accounts that vary as economic conditions change like savings and money market deposit accounts. Some CDs, usually referred to a bump-up CDs, allow you to adjust the interest rate once during the term. For example, if you had a bump-up CD that you took out at 3 percent and then interest rates jumped to 5 percent, you could choose to bump your interest rate so it would remain at 5 percent until maturity.
Warning
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Interest rates on CDs also play a factor in calculating the early withdrawal penalty if you decide to take out your money before the maturity date. Rather than paying a set fee, the fee is calculated based on the interest you accrued over a certain period of time. For example, for CDs over a year, the fee is usually several months of interest.
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