A certificate of deposit (CD) is a promissory note issued by a bank. It’s basically a loan YOU make to the bank for a specified period of time. Though there are some no-penalty CDs out there, you generally aren’t able to get your money back before the time period ends without sacrificing some of the interest and possibly paying other penalties.
How do CDs work?
Let’s assume that you purchase a $1,000 CD with an interest rate of 2 percent compounded annually and a term of one year. At year’s end, the CD will have grown to $1,020 ($1,000 x 1.02).
Generally, most bank CDs last between three months and five years so if you think you’ll need that money, bear in mind that it will be “lent” to the bank for that period of time. Once your CD reaches maturity, you usually have a choice to renew the CD at the then current rate or withdraw your principal plus interest.
CDs allow you to grow your money with a bit higher interest rates compared to regular savings accounts or money market accounts. Credit unions also have CDs but may call them “share certificates.” Just like at a regular bank, you’ll need a minimum amount to open a CD depending on the term and the interest rate offered.
CDs are a decent investment vehicle for the intermediate to long term, especially if you use a technique called “CD laddering.”
If an investor owned a single $10,000 CD that matured in five years and earned 2 percent interest per year, that $10,000 would be tied up for five years. If the prevailing interest rates increased to 3 percent, that investor would be stuck earning the lower, 2 percent rate until the CD reached maturity.
If that investor instead had five CDs worth $2,000 each that were laddered (or layered or staggered) so that each bond matured each year, he or she would only have to wait a few months to start earning a higher interest rate on a portion of his investment if interest rates increased.
At the same time, if interest rates fell from 2 percent to 1.5 percent, the investor would not be faced with putting $10,000 into a lower-earning investment all at once when the CD matured (assuming he or she would reinvest the money). Interest rates might go back up by the time the other CDs reached their maturity dates.
CDs are generally safe investments
If you obtain a CD from an FDIC insured in the USA for less than $250,000, that CD is backed by insurance and you can generally rest assured that your principle will be there. So give some consideration to CDs. They’re safe, reliable, and your principle will be there at the end of the term. You won’t earn spectacular interest rates, but you can sleep easy knowing that unlike many other investments, you won’t lose your entire nest egg.