finance

Certificate of deposit

Glossary »

If you are looking for a low-risk investment opportunity, certificates of deposit (CDs) are a good option.

CDs restrict access to your funds for a fixed period in exchange for high-yield returns when the CDs mature.

During times when the investment market is particularly volatile, CDs are more appealing as there is less risk involved, and the rates are normally better than those you get from savings accounts.


What is a certificate of deposit?

A CD is a type of savings account, usually issued by commercial banks. The accounts restrict your access to the money you invest, but in compensation they offer much higher interest rates than those associated with regular savings accounts. Long-term CDs offer the best rates, as they tie up your funds for a longer period of time and involve more risk.


How CDs work

When you purchase a CD, you invest a specific amount of money for a set period. The issuer pays interest at regular intervals, until the date of maturity, at which time you receive your original investment, plus all of the interest. For example, a $20,000 CD with a 2-year term and a 3 percent rate of interest returns $21,218 when it reaches maturity.

Benefits

  • Low risk: CDs are a low-risk investment opportunity. You don't need to know anything about the investment markets; you just need a lump sum that you won't need access to for the CD's term.
  • High yield: CDs offer better interest rates than regular savings accounts to compensate for the loss of liquidity in your money.
  • Insured: The Federal Deposit Insurance Corp. (FDIC) insures deposits with CDs up to the value of $250,000. If the issuer falls on hard times, your original investment is secure.
  • Various options: Basic CDs pay a fixed rate until they reach maturity, but there are other options available, such as variable-rate and long-term CDs. This makes it easier to find a CD that is right for you.

Potential drawbacks

  • Loss of liquidity: CDs afford to pay high rates by locking you out from accessing the invested funds. If you are ever in a situation where you need to access the money, there are early termination fees assessed.

    If you terminate in the very early stages, you may lose all of the interest your investment had accrued.

  • Potential fraud: Most people buy CDs from banks, so the risk of fraud is minimal.

However, it's possible to purchase CDs through brokerage firms. These firms negotiate better rates with financial institutions in exchange for bringing in a high volume of investors.

Investing in brokered CDs increases the risk of fraud, making it necessary to research the firm in greater detail before making any payments. Brokered CDs also may have additional risks associated with gaining early access to your money, so you need to read the fine print carefully.

  • Calls: Callable CDs include the option for the issuer to terminate your account early, potentially limiting the return on your initial investment. However, the call date is not the same as the maturation date, and the call doesn't grant you the option of early termination. Even after the call date has passed, it may still cost you money to withdraw your funds before maturation.

Choosing a certificate of deposit

CDs are a solid, low-risk investment option for many people, but it pays to choose a product with care. The highest-yield accounts may not be the right ones, as they usually entail a longer maturation period and higher risks.

If you intend to buy a CD, spend some time looking at the available options, paying particular attention to the interest rates, the maturation date and whether the issuer has put a call feature in place for the option to terminate your investment early.

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