Certificates of deposit are offered by banks and other financial institutions. With a CD, you deposit a fixed amount at the start and then leave it in the account for a specified period of time in return for a predetermined rate of interest. Depending on your investment objectives, CDs might be a good way to invest your money.
Rate of Return
The rate of return on CDs doesn't appeal to everyone. Sure, they get higher interest rates than other deposit accounts, such as a checking account or savings account. They generally won't match the higher returns on investments with more risk, however, such as mutual funds and stocks. What you give up in higher returns, you get back in security because your interest rate is generally locked in for the duration of the CD. Plus, when the market has a bad year, your CD won't lose money.
With a CD, the deposit is insured by the Federal Deposit Insurance Corporation -- up to the annual limit -- assuming you get the CD from an FDIC-insured bank. As of 2013, the limit is $250,000 per bank. That means that if a bank goes belly up, your deposits in CDs up to that amount is safe. So, if you absolutely can't afford a loss, or you're just risk-averse, CDs could offer you a good option.
Early Withdrawal Penalties
The price you pay for getting an interest rate higher than those available for more liquid deposit accounts is a significant early withdrawal penalty if you take the money out of the CD before it matures. Banks use the money deposited in CDs -- money that you've promised to leave in the bank for a certain period of time -- to make loans. Although penalties vary from bank to bank, you typically must pay about three months of interest on CDs that mature in less than one year and six months of interest on CDs whose period of maturity is a year or longer.
One way to minimize the risk of having to dip into your CD investments before they mature is to ladder them. When you set up your ladder, you invest in multiple CDs with different maturity dates. For example, if you want to have access to a portion of your investment at least once a year and you're going to invest $12,500, invest $2,500 in a one-year CD, $2,500 in a two-year CD, $2,500 in a three-year CD, $2,500 in a four-year CD and $2,500 in a five-year CD. As each CD matures, you have penalty-free access to its funds and -- if you choose -- may reinvest it in a new five-year CD.
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