A certificate of deposit (CD) is a fixed-deposit investment option offered by banks and lending institutions. It offers higher interest rates than conventional savings accounts because it requires investors to deposit funds for a specified term ranging from one month to more than five years. However, like savings accounts, CDs are a secure form of investment, as theyare insured by government agencies. In the US, CDs issued by banks and worth up to $100,000 are insured by Federal Deposit Insurance Corporation (FDIC).
How Certificates of Deposit (CD) Work?
A person can buy a certificate of deposit (CD) by depositing the minimum requisite amount. In general, the higher the deposited amount, the better will be the interest rate offered on it. The buyer of a CD receives a written declaration or certificate wherethe applicable interest rate, term of deposit and date of maturity are stated.
At the time of maturity, buyers are entitled to receive the principle amount and the interest earned. In order to encouragebuyers to maintain their long-term investment, banking institutions levy heavy penalties on the early withdrawal of the amount deposited in a CD. The penalty can be in the form of either the interest earned over six months or an overall reduction in the interest rate.
Banking institutions have introduced a ladder CD, which provides investors the flexibility of receiving the principal amount ininstallments. This enables people to invest money in other high-interest alternatives.
Tips to Buying a Certificate of Deposit (CD)
The following tips can help you decide on a certificate of deposit:
- Consider your financial goals: The basic recipe for a successful investment is a clear vision of your financial target and risk appetite. Apart from CDs, there are various options for diversifying your investment portfolio, such as saving deposits and treasury bills. Consider all available options before making a decision. Typically, CDs offer a fixed interest rate for the entireterm of the investment. Thus, the biggest risk factor in opting for a CD is inflation, which can erode the purchasing power ofthe total returns from this investment option.
- Consider the maturity time: You money will be locked till the CD matures. So, ensure that you do not need the funds.
- Consider the rate of interest: Confirm whether the CD offers a simple or a compounded rate of interest. In case it is a compounded rate, find out whether it is compounded quarterly or annually.