What Is a Certificate of Deposit & How Does It Work?

Okay, so someone mentioned that CDs are a safe way to start investing all that hard earned cash you’ve been saving, and you’re thinking most people just download MP3s, so why should you invest in CDs? Well, the type of CD they’re talking about is a certificate of deposit, and understanding how they work will help you determine if they are a good investment option to help you meet your financial goals.

The Basics

A certificate of deposit (CD) is similar to a savings account, only it has a higher interest rate and you don’t have access to your money for a period of time. Basically, when you purchase a CD from a bank you invest a certain amount of money for a specific period of time. Interest will accrue periodically throughout the term of the deposit until it reaches maturity. CDs can be purchased through banks or investment firms and are typically offered at fixed rates, although some investment institutions may offer adjustable interest rates.

Doing the Math

Interest on CDs is compounded periodically – typically daily, monthly or semi-annually – so the longer you leave your money in a CD, the larger your return will be. Compounded interest is interest paid on the principal plus the accrued interest. Fortunately you don’t have to be a mathematician to figure out how much you can make on a CD, but you will find out that CDs aren’t a way to get rich quick. For example, using the CD calculator at Bankrate.com, a \$1,000 deposit with a 1.3 percent interest rate compounded daily for five years will result in only a \$67 return. So, at the end of the term of the CD, you would be paid \$1,067, principal plus interest. The more you invest, the more you make. A \$20,000 investment with the same variables of interest rate and term would result in a \$1,343 return.

Pros and Cons

If you’re looking for a way to invest money but aren’t looking to take any big risks, CDs are a great way to go. While the returns may not be as high as riskier investment options, you’ll sleep a little easier knowing you aren’t losing any money with a certificate of deposit. Certificates of deposit require a certain amount of time to mature – usually between one and five years – during which time you won’t be able to access your money without paying a penalty or forfeiting accrued interest, depending on the terms of agreement at the time you purchased the CD. When you purchase a fixed rate CD you are locked in at that interest rate. If rates increase, you’ll still be locked in at the lower rate. Alternatively, if rates decrease, the bank may be able to “call” the CD, meaning they may terminate your investment rather than continue paying you higher rates.

Tips

According to both the U.S. Securities and Exchange Commission (SEC) and the Federal Deposit Insurance Corporation (FDIC), it is common for investors to misunderstand the terms of a certificate of deposit, so make sure you know exactly how long it will take for your investment to mature before you purchase a CD. Read the fine print to learn all the details about early withdrawal penalties and how you will be paid when the CD matures. If you purchase your CD through an investment broker, find out which bank it will be purchased from. CDs are federally insured up to \$250,000, but if you have other investments being insured through the same bank you will only be insured for the maximum. Also, CD brokers are not required to obtain any special licensing. so do your homework before entrusting them with your money. You can check out many brokerage firms through the SEC’s Central Registration Depository, a computerized database containing information about brokers and representatives.

About the Author

Based in South Florida, Leann Harms has been writing since 2008. Her design, technology, business and entertainment articles have appeared in "Design Trade" magazine and Web sites including eHow. Harms has a Bachelor of Arts in English from Florida Atlantic University.