How Do CD Accounts Work

Certificates of deposits aren’t technically considered accounts; however, the investment vehicles work very much like any other account you might find in a bank with one major exception: you won’t have as much access to your money.

To put it simply, investments made in certificates of deposit are made under the condition that investors do not withdraw their money for a mandated period of time. Where many people believe that it is actually bank account deposits that are lent to others to buy cars, homes, and whatever else borrowers might need, the rapidly fluctuating account balances for checking and savings accounts make them poor investment funds for banks.

As such, banks have an incentive to pay investors who will not only invest their money with the bank, but also promise to keep their money at the bank for a period of time that is conducive to later lending. Where you could easily deposit $100,000 in a savings account tomorrow, you could just as easily withdraw it the next day. In one day’s time, the bank would have been obliged to pay you interest on your account, even if there wasn’t enough time for the bank to lend the funds out to achieve maximum return on the short-term account balance.

Rates and Time
The rate that is paid on any particular certificate of deposit is very much intertwined with the length of time that investors are willing to part with their money. Investors who seek to lock up their funds for a period of less than one year will see very small returns, often only forty to fifty basis points (.40% to .50%) more than your standard bank account.

However, those who are willing to lock up their funds in a certificate of deposit for a longer period of time are rewarded with significantly higher returns on their investments. A three-year CD, for example, might pay upwards of 200 to 300 basis points more than a savings account. A five-year CD, will pay the most of any CD available at a banking institution, often as much as 300+ basis points greater than a savings account. That works out to a difference of 2-4% per year in annual returns, just for promising the bank that you will not need your investment capital for an extended period of time.

Investing in a Certificate of Deposit
There are few investment vehicles that are as widely-available, or as easy to purchase as the infamous certificate of deposit. Where stocks require a brokerage account at the minimum, and the hiring of a stockbroker at the maximum, buying a certificate of deposit requires only a short stop at a local bank or credit union. Alternatively, those with online banking accounts often have the ability to buy CDs over the internet, with only a few clicks online.

Keep in mind that few ever get rich investing in certificates of deposit. As a general rule, the rate of return of any particular investment runs inversely to its risk. Certificates of deposit investments of $250,000 are protected by law; the FDIC, a federal institution, pledges to protect investor capital up to $250,000 per person, per bank. That said, CDs often provide returns that are in line with US Federal debt, as the final counterparty—the US Government—is at the basis of each investment.

While CDs won’t make you rich, they’ll certainly help better protect what you have saved against inflation, and they often provide net-positive returns when inflation is considered. Plus, where your excess savings earn less than one-percent in savings accounts, and zero percent in checking accounts, CDs are the perfect blend of safety, regularity, and performance for money you’re not yet willing to risk in more speculative investments.

Related Information