Certificates Of Deposit Explained

Summary: A Certificate of Deposit (CD) is a method of saving. Much like a regular savings account in a bank, a CD is one of the safest places to keep your money and earn interest. A CD will often pay a higher rate of interest rate than a normal bank account.



The main difference between a regular savings account and a Certificate of Deposit is that invested money has to remain in a CD for a specific amount of time. The time period is determined at the outset and can be anywhere from 3 months to 20 years.

Once money is invested it is locked away and the investor is unable to access the money unless a penalty or interest charge is paid to do so. This penalty is often the equivalent of 3 to 6 months interest. In other words, the interest that would have been earned on the invested money during a period of months is forfeited.

Since Certificates of Deposit are sold en masse, they will normally have a maturity date. This is the date when the investor is able to withdraw funds or - more usually - take the entire amount of investment and interest without penalty.

Generally the longer the time period of the CD, the greater the interest rate that will be earned. The reason for this is that banks will lend the invested money to other customers and make a profit on the difference between deposit and loan interest rates.

Longer term deposits offer a level of guaranteed funding that helps to maintain the financial security of the bank or financial institution. Therefore, the longer funds are invested for, the more money can be made, safely.

Interest is earned on the CD and is added on to the principal amount and then interest is paid on the interest. This is known as compounded interest and is a great may to use money to make money.

In the United States, Certificates of Deposit are FDIC insured (Federal Deposit Insurance Corporation), this is a federal program that guarantees deposits making it a safe investment suitable for low risk investors.

It is a good idea to consider a CD if:

You have money you will not need for a while.

You do not like taking risks.

You want a better interest rate than an savings account or a money market account.

However, as with most deposit based investments, there can be a very real risk to money that is invested. As mentioned above, this is not usually a risk of default by the financial institution, but instead the potential impact of inflation on the purchasing power of the money invested. In quick and simple terms, if money is earning interest at a rate of 5% per year, but inflation is actually 8% per year, then the spending power of the invested money is falling with every month and year that passes.

Inflation is less obvious to the eye than a bank default which makes it less of a worry for many people, but it is a very serious factor to consider when making any long-term investment.