Certificates of Deposit: Understanding the Basics
A certificate of deposit (also known as a CD) can be a good investment for those looking for short-term stability. They can also be part of a longer-term strategy to grow and accumulate wealth over time. They offer greater returns than a standard savings account, while providing the same levels of security.
Every investment represents a trade-off between short-term liquidity and long-term benefits. This proposition is written into the definition of a CD, which explicitly offers a guaranteed return in exchange for leaving your monies untouched for a pre-defined period of time.
For many people, this makes for a smart, healthy investment. Before proceeding, it is important to understand why banks offer CDs, when you should consider purchasing one, and how you can use them to increase your wealth.
Certificates of Deposits vs. Savings Accounts
Before delving into the differences between these two investments, it is important to understand what they have in common.
Assuming you invest with a bank that is FDIC-insured or a credit union that is NCUA-insured, any CD or savings account in your possession is guaranteed against losses by the Federal government up to $250,000. This makes both of these options extremely safe.
The money you place in a savings account remains easily accessible, however, which is where the two different types of investments diverge. While banks can lend the money you deposit in your savings account, they need to keep a certain amount of capital on hand for when individuals wish to withdraw their savings for personal use.
While you can usually withdraw your money from a CD in the event of an emergency, there is usually a penalty or fee for doing so. Banks understand that most people will choose to keep the monies they have invested in a CD untouched until they mature, which affords them the certainty to use that money to provide capital for those wishing to receive a loan.
For this reason, banks can offer higher interest rates on CDs than on standard savings accounts. In essence, you are trading access for a higher rate of return.
How to Find the Right Certificate of Deposit for You
There are a number of considerations to make when deciding on the best CD for your needs.
- (1) Time period: CDs have different rates of maturity, ranging from weeks to years. While the longer you keep your money invested the greater the eventual pay-out, not everyone has the luxury of parting with their money for years at a time. The interest rates of CDs will depend on the overall interest rates in the market, so if you expect rates to rise in the coming year it is probably better not to get locked into a long-term investment.
- (2) Rates of return: Different financial institutions will offer various incentives to get you to invest with them. These include higher interest rates and opportunities to increase your rates of return during the life of your investment.
- (3) Penalties for early withdrawal: While you will ideally keep your money invested for the entire period of your CD, your circumstances could change and you may need to access it earlier than expected. Be sure to understand the cost of making an early withdrawal before purchasing a CD.
- (4) Rolling-over: After your CD matures, you can either take your money out or re-invest it in a CD with similar terms. This is known as rolling over your investment. This will sometimes happen automatically if you do not elect to take any action. Rolling over your CDs will allow you to benefit from the magic of compound interest, whereby your interest will begin to accumulate interest.
You can experiment with TipRanks’ compound interest calculator to understand how the various parameters of your investment–including interest rate, timeframe, and compounding frequency–will impact the rate and growth of your overall investment.
Conclusion: Certificates of Deposit
Certificates of Deposit are a good option for those looking for safe, higher-earning investments. While you lose the flexibility that comes with savings accounts, you will gain the higher interest rates that CDs are known for.
Before proceeding with any investment, make sure you consider your investment options and the various CDs that different financial institutions are offering.
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