What is a certificate of deposit? A certificate of deposit (or CD) counts as a go-to investment for many people. A CD doesn’t require you to pay attention to the ever-changing stock market. It exists as an investment outside of that. In some respects, a CD is a set-it-and-forget-it investment. However, to be an informed investor, it’s beneficial to know what a CD is. Why is it a good investment for you? Moreover, what should you do with your money once your CD reaches maturity?
The Concept of a Certificate of Deposit
Let’s start by finding out what is a certificate of deposit. Certificates of deposit are like savings accounts. However, they have an end date on the investment and a higher earned interest rate than the average savings account. Basically, this means that you agree to put your money into a CD account for a period of time, say two years. At the end of the two years, your savings time is over. Whatever interest you accrue during that time is over as well. This end date is called a fixed maturity date.
Once your maturity date comes, you can take the money out of the account. You can spend it or put it into another type of investment vehicle, including another CD. Once the CD reaches its maturity date, that’s when all the interest you earn on the CD has accrued. You can also collect your money without penalty fees at that point.
Although common CD maturity rates are one to five years, some can have short-terms maturity rates. That’s when the CD comes to maturity in 28 days or so. The CDs with the longest maturity rate, five years or more, typically make the investor the most money. Now you can brag to all your friends that you know the answer to the question: What is a certificate of deposit!
Advantages and Disadvantages of CDs
Like any investment, a certificate of deposit has both advantages and disadvantages. You need to know them both, not just what is a certificate of deposit.
Advantages of CDs
- CDs count among the safest investments around. You know what the interest rate will be going into the investment. That is unless you invest in a CD with a variable interest rate. Also, you know that you will at least get the minimum that you put into the CD back out of it when it matures.
- The FDIC insures certificates of deposit for up to $250,000. This insurance exists separate from your bank. Therefore, this means that if your bank goes out of business, your CD is still protected.
- The income you earn on a CD can increase without tying up your money if you practice laddering. Laddering is a way to invest in CDs and have access to the money at the same time.
Basically, if you invest a certain amount of money in a CD – say $10,000 – you can put some of it into five different CDs. This will break down to a one-year, a two-year, a three-year, a four-year, and a five-year.
Once the first CD is mature, you roll it over into a five-year CD. You keep doing this until all of your CDs are five-year CDs. Therefore, you have a CD maturing every year. This gives you access to your CD money every year. Five-year CDs typically have the highest interest rate.
- You can put a certificate of deposit into your IRA just like any other investment. A CD in this situation can guarantee a return on your retirement income over the long haul.
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Disadvantages of CDs
- The interest rate is low compared to other investments like mutual funds. Basically, with a CD, you’re trading a very high yield interest rate for lower risk, safer investments. That is up to six percent or more on some of the riskier investments. Typically, the younger the investor is the more he/ she can invest in riskier investments. Usually, this investor will have some safe investments like CDs mixed in with a high-yield mutual fund. The latter has a higher overall return rate, but higher risks, too.
- Although CDs can be likened to a type of savings account, they differ in a key way. If you withdraw money from your CD before its maturity date, you’ll get penalized for doing so.
- Some CDs have a minimum investment rate. For example, you may have to invest $500 or a $1,000 or more before you can invest in a particular certificate of deposit.
- There are some CDs that are riskier than others. Callable CDs are among them. With a callable CD, the bank can decide to end the terms of your deposit. That is if the bank isn’t making the kind of return on the CD that it wishes to. In that case, your CD will be returned to you before it can reach its age of maturity.
- You have to keep track of when your CD matures. If you don’t, your financial institution may just automatically roll your money into a new investment.
If you don’t tell your bank what to do with your money after the CD matures, you may find your money in another CD. While this may not seem bad, it actually locks your money up with the same early withdrawal penalties as before.
- You’ll need to place your CDs in different financial institutions if the amount you have in CDs goes higher than the FDIC insurance rate of $250,000.
Your deposit insurance, at least as far as a single lending institution is concerned, goes away after you reach the $250,000 mark. Any money above that will need to be put into another bank or credit union CD.
A certificate of deposit counts among the safest investments you can make. Although there are some drawbacks to a CD – namely, you risk paying penalty fees with you withdraw your money from the CD too early, it is a good overall investment for those who want investments with few risks.
So, what is a certificate of deposit? Have you invested in CDs? What is your experience with them? Leave your comments below.
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