What it means
When you buy a fixed-rate CD, you hand a lump sum to a bank for a stated term, such as six months, two years or five years. The bank agrees to pay a specific interest rate for the whole term and to return your original deposit on the maturity date.
Because the rate is fixed, you know exactly how much you will have at the end. For a business, a CD is a way to earn a predictable return on cash that is not needed in the short term.
It suits money earmarked for a known future cost, such as a tax payment, a lease deposit or a planned equipment purchase. The certainty makes budgeting and cash flow forecasting easier.
The trade-off is access. Withdrawing early usually triggers a penalty, often expressed as a number of months of interest, so the product only makes sense for money you are confident you will not need.
Deposits at insured institutions are often protected up to a limit set by the deposit insurance scheme, which is one reason CDs are viewed as low-risk. Interest can be paid out regularly or added to the balance, which is called compounding (earning interest on your earlier interest).
The more often interest compounds, the higher the effective return. Banks usually quote the annual percentage yield (APY), which already includes the effect of compounding, so offers can be compared fairly.
The main risk is not default but opportunity cost. If market rates rise after you lock in, you are stuck with the lower rate until maturity, but if rates fall you are glad you locked in.
Many savers manage this by laddering, which means splitting money across CDs with different maturities. Inflation is the other quiet risk.
A fixed rate that looks pleasant on paper may fall short of rising prices, so the real return, meaning the return after inflation, can be small or even negative.
In practice
Real-world examples.
Example
A small architecture practice knows it must pay a $30,000 insurance premium in 12 months. It places the money in a 12-month fixed-rate CD, earns a guaranteed return and has the cash ready on the due date.
Example
A retired teacher builds a ladder of five CDs with maturities from one to five years. Each year one CD matures, giving her access to cash and a chance to reinvest at current rates.
Example
A software start-up with surplus cash from a funding round puts $500,000 into a nine-month CD. The finance lead accepts the early-withdrawal penalty because the forecast shows the cash will not be needed before then.
Formula
Calculation
Maturity value = Principal x (1 + annual rate) ^ number of years, for interest compounded once a year.
Suppose a company places $20,000 in a three-year fixed-rate CD at 4% a year. After year 1 the balance is 20,000 x 1.04 = $20,800. After year 2 it is 20,800 x 1.04 = $21,632. After year 3 it is 21,632 x 1.04 = $22,497.28. The interest earned is 22,497.28 - 20,000 = $2,497.28.Case study
Seen in the real world.
Greenfield Bakeries is an illustrative, fictional business that received a one-off $150,000 customer prepayment for a contract starting in 18 months. The owner could have left it in a current account earning almost nothing, but she wanted to avoid spending it on day-to-day costs.
She placed the money in an 18-month fixed-rate CD at an agreed rate, which gave a known return and removed the temptation to dip into the funds. When the contract started, the deposit matured within a week of the first supplier payment.
Midway through the term, market rates rose and a colleague suggested she had missed out. The illustrative point is that she had traded some upside for certainty, and the certainty was exactly what the plan needed.
Watch out
Common mistakes.
- Locking up money that may be needed before maturity, then paying an early-withdrawal penalty that wipes out the interest earned.
- Comparing a quoted rate with an APY as if they were the same, when the APY includes compounding and the plain rate does not.
- Assuming a fixed rate protects against every risk, when inflation can still erode the real value of the return.
Questions
People also ask.
What happens at maturity?
The bank returns your deposit plus interest, and many banks automatically renew the CD for a new term unless you instruct otherwise, so check the notice window.
Is a fixed-rate CD the same as a savings account?
No, a savings account usually has a variable rate and easy access, while a CD fixes the rate and restricts access for the full term.
Can the bank change my rate during the term?
No, that is the defining feature of a fixed-rate CD, although a variable-rate CD would allow the rate to move.
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