What is a Certificate of Deposit?

A certificate of deposit, also known as a CD, is a short to medium term investment made with a bank or savings and loans institution.

The basic idea is that you agree to deposit a certain sum of money for a period of time, typically anywhere from three months to six years, in exchange for a locked interest rate.

This interest rate will generally be higher than that of a traditional savings account. After the length of the CD has expired, the initial balance will have increased substantially due to the accrued interest.

“The reason banks are able to offer higher interest rates for CD’s is because they are considered long-term investments. The investor agrees to keep a specific amount of money in the bank for X amount of time. “

A Certificate of Deposit is essentially a loan made by the investor to the bank, which then generates a promissory note that obligates the bank to repay the loan at the agreed upon time. In return the investor agrees not to withdraw, deposit, or otherwise alter the principle sum for the length of time the CD is valid.

The way a Certificate of Deposit works is completely different to other forms of investing such as buying stocks or ETF’s which deal with equity. With Certificate of Deposits, you are essentially dealing with debt.

There are heavy penalties for withdrawing money from a CD fund prior to maturity; most commonly a slashed interest rate.

Investing with certificate of deposits
Investing with certificate of deposits

A CD is considered a safe investment method as it is typically held at FDIC insured banks or, in the case of credit unions, the NCUA. The FDIC insures CDs for up to $250,000, which means that your money will not disappear should the institution that holds the certificate of deposit fail.

The amount of interest generated by a CD is variable based on the amount of time it is in place. Longer term CDs will have higher interest rates, which makes them a good choice for individuals who wish to make an investment but will not need to access their money for some time.

The interest payments can be paid into a separate savings or checking account as soon as its earned, kept in the CD account to increase the balance and compound the interest, or rolled into a longer-term CD fund to take advantage of higher interest rates.

How does a Certificate of Deposit Work?

A certificate of deposit or CD is a short to medium term investment that is made with a bank or credit union. CDs work in a way that is very similar to a traditional savings account with a few important distinctions.

In the simplest terms, a CD works like this: you deposit a sum with bank, wait a specified period of time, and then withdraw the sum plus interest.

Banks typically offer a higher interest rate on CD’s. The reason for this is that a CD is essentially a loan made by the investor to the bank with the stipulation that the principle sum will not be altered for an agreed upon amount of time, which can be anything from three months to six years.

In return, the bank offers a fixed interest rate to the investor based on the length of time the CD is valid for and the amount of money deposited.

The bank then generates a promissory note which obligates them to pay back the loan once the CD has matured (the financial term for the date the CD expires). The interest can either be paid out as it accrues or in a lump sum.

Although CD interest rates are generally high, the best interest rates are reserved for longer term CDs with larger principle sums.

Example of a Certificate of Deposit

Certificate of Deposit Example from Bank of America
Certificate of Deposit Example from Bank of America (Source)

CDs are considered a safe investment method at they are held at FDIC insured banks or NCUA insured credit unions.

Should the investor decide to withdraw their money prior to the CD reaching maturity, they will only lose the compounded interest, not the original sum.

Money can only be withdrawn from CDs after the maturity is reached, so if you may need immediate access to your money but would still like to earn some interest, we recommend a savings account.

There are penalties to withdrawing money from a CD before the agreed upon length of time has passed. The institution that holds the CD should inform investors of these penalties when the CD is purchased.

Generally banks will slash interest rates or ask the investor to. The principle sum may or may not be reduced. In addition, a bank can call or cancel a CD prior to maturity if necessary.

Who Offers Certificates of Deposit?

A certificate of deposit or CD is an excellent way for individuals to invest their money safely. CDs work in a similar way to savings accounts in that the financial institution pays interest on the principle; however interest rates are generally more favorable for CDs.

Why?

Because of the agreement made when the CD is purchased. Basically, the investor agrees to deposit a sum in the bank and keep it there for a specified amount of time. The bank creates a promissory note that obligates them to pay back the loan once the CD reaches maturity (the financial term for the date of expiry).

In return for honoring the terms of the CD, the bank pays a high interest rate on the CD that can either be paid out as it accrues or added to the principle sum.

Where to buy Certificate of Deposits?

Once you have decided to invest in a CD, you may be at a loss as to where you can find one. Banks and credit unions are the most common issuers of CDs.

Although smaller institutions that do not have FDIC insurance will offer higher interest rates, their CDs are a riskier investment despite the promise of better profit.

In order to find a financial institution that offers the best interest rates, you can shop around in your area. Many institutions that need deposits often offer great rates on CDs.

Online-only banks also sell CDs and can often give customers a better deal due to their low overhead. Finally, you can work with a brokerage firm to find the best CD rates available.

However, a brokered CD can be expensive to get out should you need to withdraw funds before maturity.

Keep in mind that although CDs are generally risk-free, they will never yield as high a profit as investments in the stock market do. In addition, the investor must be comfortable with having their money be inaccessible for the period of the CD.

There can be harsh penalties for early withdrawal, including the loss on three to six months of interest depending on the institution.

Certificates of Deposit vs. Savings Accounts

Certificates of Deposit, commonly known as CDs, are similar to savings accounts in that they are a smart way to yield profit on your deposit through the accrual of interest. However, there are several distinct differences to the way financial institutions approach CDs as oppose to savings accounts.

The main distinction is that while savings accounts have lower interest rates, the investor has continual access to the funds. With CDs, the investor enjoys a higher interest rate and greater profit yield but will not be able to withdraw any of the funds for a fixed amount of time.

When you open a checking account at a bank or credit union, you might be offered a savings account as well. You will earn compounded interest on the principle sum in the account, which basically means that the interest earned will be added to the principle for the calculation of the next month’s interest.

You will also have ready access to these funds in necessary. However there are some downsides.

For example, some banks require that customers keep a minimum balance in their savings account in order to avoid a monthly fee. If you are financial able to keep a minimum balance in a savings account, a CD might be better option for you.

CDs are essentially an agreement made the bank that the investor will deposit a fixed sum of money for a fixed amount of time. In return, the bank offers a higher interest rate.

The catch is that the investor must agree to not withdraw any funds from the CD until it reaches maturity (the financial term for the expiration date).

Should they withdraw money, they will be penalized. CDs can last anything from three months to six years, with longer-term CDs generally having more favorable interest rates.

Similar to a savings account, CD’s offer compounded interest.

However, CD investors can choose to receive interest payments as they accrue or have them added to the principle.

Deciding whether a savings account or a CD is the best choice for your money, speak to your bank about what kind of interest rates they can offer you.

If it is possible for you to invest a large sum of money without needing immediate access to it, a CD is probably the best bet.

If not, a savings account might be a better option.