What is a Certificate of Deposit

A certificate of deposit, or what is commonly termed CD, is probably one of the safest methods of investment available. CDs are perfect for the investor who is happy to be on the lower end of the reward and risk spectrum. Interest, similar to a savings account, is paid on the money invested in the CD; but more often than not, at a greater rate than with a savings account. In other words, it comes with a higher APY (annual percentage yielded).

The reason that CDs commonly pay out more than savings accounts is because you are doing the bank a favor. You’re allowing them to use the money that you have invested in your CD, for the promised period of time, for whatever purpose as they deem appropriate (i.e. investing or lending to other customers). They are returning the favor by giving you increased interest rates over those typically assigned to savings accounts.

What is a Certificate of Deposit
A certificate of deposit is what is known as a “time deposit” into a bank. Where you can add and subtract money from your checking and savings account on a whim, certificates of deposit require that investments stay in the bank for a period ranging from one-month up to five years, and in rare occurrences, sometimes even longer. Because a bank requires that you lock in your deposit for a period of time, it is willing to pay you higher rates of interest. You see, banks borrow from their customers and lend to other customers in the form of home loans, car loans, and even credit cards. However, unless they know with certainty that you will not withdraw your money for a long period of time, it just doesn’t make sense for them to give you good rates by lending out your money. If you were to lock up your funds for five years, though, the bank could arrange to make a four year car loan with your cash and offer up to you a higher rate of return, since the bank will be able to use your funds for a longer period of time, and thus generate higher rates of return for itself, as well.

So, How Does a CD Work?
The purchase of the CD is probably the easiest part. Walk into your credit union or bank, request the assistance of a teller, and simply inform them that you’d like to purchase a CD. You’ll be required to enter some disclosure information on a form and the money will then be moved into the CD. An actual certificate is not required due to the fact that you will ordinarily see this transaction listed in a specific category on your statement. The interest paid on your CD can either be spent or reinvested, though reinvesting is a better way to make your money grow. This is called compounding your interest and allows your account to increase at a higher rate of speed. Upon maturity, the time at which the promised length of duration ends, your CD will automatically be reinvested by the bank into a new CD unless you notify them (an individual usually has approximately 10 to 15 days in which to do this) otherwise. Be sure you understand the terms of your CD so that, should you not wish the money from your CD to be rolled into a new CD, you will be fully aware of what kind of action needs to be taken and how much time you have in which to take it.

After the CD has matured, you will have a number of options from which you can choose. You can have the interest accrued on the mature CD to your checking or savings account, after which the CD can be renewed for your chosen duration. Or, you can reinvest the interest along with the original amount into a new CD. Another option is to cash out the CD and get the interest and the principal placed into the account of their choice or given to them in cash.

The interested earned on your CD is subject to tax. If the principal was ever claimed as a tax deduction, there may be tax owed on it as well. Even so, it should be noted that both you and the financial institution can gain from a certificate of deposit as compared to a traditional checking or savings account. Number one, the interest rates on CDs are higher because of the longer maturity period. This allows the bank to use the money. And, the strict penalties imposed keep most CD holders from withdrawing the money, whereas with a checking or savings the money can be taken out any time the account holder wishes. Some savings and checking accounts may have minimum balance requirements and overdraft penalties that will apply if the balance drops below the required amount.

An Equation for Success
Time is equivalent to rates. That is the basic equation for setting up a CD. The longer you leave that money there (time), the higher the rate of interest will be (rates). Once again, this is a reward from the bank for doing them the favor of allowing them to use your money for a longer period of time. Every now and then however, something will happen in the economy that will offset this equation. Competitive interest rates are pretty much dictated by the state of the economy. Carefully examine the direct relationship between how long your money will be tied up versus how much you stand to gain in interest, and decide whether this is the best time for investments or whether your CD investment should be postponed until rates are on the rise.

Don’t Take the First Deal That Comes Along
Shopping for a CD is just like shopping for anything else. You have to shop around. Different credit unions and different banks offer various rates for assorted investment times when it comes to CDs. Advertisements such as newspaper ads and large banners across the front of some banks are a good way to compare competitive interest rates. Online comparison is another way to shop around for the best rates on a CD investment. Be sure that if you go with a bank that you ordinarily don’t do business with, they are trustworthy and in comfortable economic condition. Running into trouble and taking your money out too soon will result in penalties. It may, however, be more beneficial to you to purchase a CD from the establishment at which you frequently do your banking. Very often, banks will offer their best CD rates to their most valued customers. As I have stated, the longer and more you invest the better rate of interest you will be able to secure. As a cautionary note, however, be absolutely sure that your investment does not exceed FDIC Insurance limits; particularly in today’s economy.

Although CDs are some of the safest investments you can make, there are some things you need to know. Find out if your CD is callable. This means that the bank can terminate the CD, which they may do when interest rates fall, which causes you to lose your high rate of fixed interest. Stay away from callable CDs if at all possible. You can get your CD from a bank or broker, but credit unions also offer them and you may find the rates are good. Credit unions offer insurance on your funds just like banks do.

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