How Does a Certificate of Deposit (CD) Work?

by Akeia Dixon, Demand Media

    Many Americans turn to certificates of deposits when looking for a low-risk way to make money off their investments. This type of investment allows investors to receive higher interest rates than savings accounts. As an added benefit, CDs are insured by the FDIC for up to $250,000.

    Purchase

    When you decide to purchase a certificate of deposit, one of the choices you have to make is how long you wish the money to be secured. You invest a certain amount of money into the CD, whether it is $1,000 or $100,000, and determine whether you want the term to be for six months up to five years or longer.

    Compounding

    The main benefit of having a CD is the compounded-interest factor. At regular intervals, the bank that issues the CD pays you interest on your investment, which, in turn, also earns interest. All of this can be cashed out at maturity. Before signing the terms of the CD, review the information to make sure that you fully understand the length of the CD and the interest rate.

    Maturity Options and Penalties

    The idea behind the maturity date is to give you, the investor, a choice to cash out your principal and interest or reinvest into another CD. Obviously, the banks want you to reinvest so that they have more time to lend and invest your money for a return of their own. Subsequently, this is also beneficial for you since you will compound more money with time. If, however, you decide to withdraw your money prior to the maturity date, you will be forced to pay penalties. Because of this, make sure that you invest an amount of money that you do not need for a while. This ensures that you receive the maximum benefit possible from this investment.

    Risks

    One of the main items to look for when reviewing your information prior to signing any paperwork is the call feature. This allows the banker to call, or terminate, the CD before the actual maturity date; this is usually at one year or another fixed time period. This usually happens with high-yield CDs if the interest rates fall. If you are invested in a long-term CD with lower rates, you are locked in at the lower rates even if the interest rates rise. Also make sure to read and understand the fine print before investing. If you see an advertisement for an interest rate that is well above the competition, make sure that all of your questions are answered and understood. The advertisement could mean that the first $1,000 of your investment is compounded with a 5 percent interest rate and the remaining balance is compounded at 2 percent or lower.

    About the Author

    Akeia Dixon is a freelance writer who began her professional writing career in 2009 for various websites. She enjoys writing about natural health topics but also loves to research and write about her findings on any subject. She is currently in school studying psychology and sociology.