A Certificate of Deposit represents an amount of money deposited at a bank or credit union, which cannot be withdrawn for a pre-defined period or term without incurring a penalty. When the period has expired, the money can either be withdrawn or left in place for another term. Usually, the longer a Certificate of Deposit is left, the greater the financial return will be.
Certificates of Deposit, also known as CDs, have a similar function to a savings account. There is virtually no risk and all monies are insured by the Federal Deposit Insurance Corporation (FDIC), if they are held in a bank and by the National Credit Union Association (NCUA).
How CDs work
When a person ‘buys’ a CD, they are agreeing to deposit a sum of money for a set period of time with a bank or credit union. This period can be six months, one year, five years or even longer. In return for this deposit, the bank or credit union will make regular interest payments on the sum. When the period expires and the CD is redeemed, the initial sum, plus the interest accrued, will be paid out to the investor. It is important to note, however, that if the CD is redeemed before the expiration date, a penalty is levied, either in the form of a charge or by the forfeiture of interest. For example, if a five-year CD is withdrawn before it is due to mature, the investor will have to forfeit up to six months of interest.
Usually, when a CD reaches maturity, the owner will have around 10-15 days to decide whether they wish to withdraw the money or leave it where it is to reinvest in another CD. If no decision is made by the owner, the bank may automatically reinvest the CD on his or her behalf.
Things to look out for when considering a CD
It is essential to ensure that the CD is being bought from a certified bank, insured by the FDIC or if a credit union, the NCUA. Confirm the date when the CD matures and check the contract to see if it includes an automatic renewal clause. The withdrawal penalties will vary from bank to bank, so it is worth shopping around to get the best deal.
CDs that are fixed for a longer term pay higher interest rates than those of shorter duration. CD interest rates rise and fall, influenced by other economic factors and it is worthwhile comparing the rates offered by several banks to see whether a short or long-term CD is most suitable.
A strategy that might be worthwhile considering, though it is perhaps a little time consuming, is ‘CD laddering’. This means dividing available funds up and placing them in several CDs at one time. Each CD has a different maturity date, which gives the investor more liquidity and flexibility with his or her money. This type of investment requires careful monitoring to ensure that maturity dates are not missed.