What Is A Certificate of Deposit

Certificates of deposit are FDIC insured time-based savings of account.  You basically are committing your money to remain in the certificate of deposit for a predetermined amount of time and in exchange for the stability of the investment, the financial institution will issue you a fixed interest rate.  Typically the longer you leave your money in the market, the higher interest rate you will receive.  However, currently interest rates have been in the tank and where as a few years ago I was able to lock-in a 5-year CD for 4% interest, now you’d be lucky to get 1% due to the low interest rates of the Federal reserve.

Certificate of Deposit Definition

A savings certificate entitling the bearer to receive interest. A CD bears a maturity date, a specified fixed interest rate and can be issued in any denomination. CDs are generally issued by commercial banks and are insured by the FDIC. The term of a CD generally ranges from one month to five years.

Advantages and Disadvantages of a Certificate of Deposit

Certificates of deposit are advantageous for conservative investors while there are also a few disadvantages, if you’re looking for safety of principal, a CD is probably one of your best bets.  When looking at the advantages and disadvantages of a certificate of deposit, it usually comes down to a few points:  safety of principal, interest rates and liquidity.

Advantages of a Certificate of Deposit

Certificates Of Deposit Are Safe and Secure

So long as your CD is issued by a federally insured bank or federally insured credit union, your money is safe and sound.  The bank will pay you back your principal and accrued interest when your CD matures – that is when the time period you chose expires.

If for some unforeseen reason your bank fails, the federal government will pay you your principal and interest as of the day the bank closes its doors.  It is important to note that CDs are insured up to $250,000 per financial istitution – which covers ALL of your deposit accounts at that bank.  So if you’re rolling in the dough, you may need to hold accounts at various financial institutions to ensure you don’t max-out the FDIC insurance limit.

Certificates of Deposit Are Easy To Open

CDs are extremely easy to obtain.  You can simply walk into your bank and purchase a CD over the counter.  If you prefer to bank online, you can easily purchase a CD right from the online banking interface from the major financial institutions.

For instance, we have an account with Capital One 360.  With a few mouse clicks, I can transfer funds from a savings or checking account and lock them into a CD with a guaranteed interest rate.  There typically zero fees when opening a Certificate of Deposit, and the interest rate is guaranteed until the CD matures.

Disadvantages of a Certificate of Deposit

CDs are not Liquid

One main disadvantage of a CD is that you have to tie-up your money for a specified period of time.  The different date ranges for CDs typically range from 6 months up to 5 years.  If you need to pull-out your money before the maturity date of you CD, you could be hit with an early withdrawal penalty – this penalty is usually about 3 months worth of interest.

Certificates of Deposit offer lower interest rates

The price of safety of principal usually results in lower interest rates.  As of 2014, a 5-year CD is only paying a measly .9% interest rate per year!  This means that on an investment of $1000, you will only make $9 in interest.  Compare this back to 2005 when you could lock-in a 60-month CD with a 4.5% interest rate.

This goes to show that locking in an interest rate when the rates are high can be very advantageous, however, CDs right now are not a very attractive place to put your money.

What is a certificate of deposit used for?

A certificate of deposit is simply used for saving money.  Think of it as a savings account that you can not withdraw from.  CDs typically pay higher interest rates in return for knowing they’ll have your money in the account for a specific period of time.

Certificate of Deposit Basics

  • An insured interest earning savings tool that allows restricted access to the funds
  • Deposits have to be held for a certain length of time
  • Interest is guaranteed
  • Interest earned varies depending on length of time and amount of money deposited
  • CDs typically have higher rates of return compared to traditional savings and money market accounts
  • CDs are less liquid than a checking account, savings account or money market account
  • Some banks may charge up to a 20% early withdraw fee – most charge 3 months of interest – make sure to ask your bank before you buy a CD
  • CDs range from $100 up to $250,000
  • CDs are very low risk and there are no fees

Types of CDs

Most CDs are offered with fixed interest rates and a term.  However, some financial institutions have implemented variations of the Certificate of Deposit.

  • Variable-rate CD – often times tied to market returns or will let the depositor take advantages of future interest rate increases.
  • Low/no-penalty for early withdrawal
  • Jumbo CD – CDs that carry higher interest rates when the depositor deposits a large sum of money into the account.  This can vary by institution, but think getting an extra 1% when you deposit $100K

What Are CD Ladders?

Many consumers want to take advantage of the better interest rates on 3 and 5 year CDs, but don’t want to tie up their cash for that long.  A resolution to this would be to open a CD ladder.  What a CD ladder really means is you have opened several CDs with varying time frames.  You’d invest $1000 into a 6-month, 1-year, 3-year and 5-year CD (maybe more).  This means that ever 6 months one of your CDs will mature at which time you can choose to use the money or renew the CD for a longer term.

You can repeat the CD laddering process until you have one 5-year CD maturing each year, thus always being able to take advantage of the higher interest rates yet always having some of your money available penalty free.