What is a Certificate of Deposit?

A certificate of deposit is a special account which you open at a financial institution (bank, credit union, savings and loan, etc.) on which you earn interest. Typically the interest rate is higher than that of an ordinary savings account however if you redeem the CD before its maturity you will probably have to pay an early withdrawal penalty.

Maturity on CDs vary from six months to five years or more. Once matured, you receive the money you deposited along with the accrued interest. There are some CDs which periodically pay you the interest directly or by transferring it into a checking or savings account.

CDs are federally insured up to $250,000 which generally makes it a safe investment for beginners however the Securities and Exchange Commission recommends closely reading all of the fine print and verifying the interest rate you have been offered.

Among the things you need to note is whether the institution will notify you before automatically rolling over your mature CD following a grace period.

In some long-term, high-yields, the issuing institution may have a “call” feature in which it may choose to terminate the CD after a fixed period of time if the interest rates fall from the rate promised you. On the other hand, if the rates rise your CD remains locked at the lower rate and you cannot terminate the CD without a penalty.

Some CDs offer a variable interest rate with a structure in which interest rates can increase or decrease over time. Variable rates may be based on the performance of a market index such as the Dow Jones.

Brokered CDs are sometimes a draw for some investors because they often have higher interest rates but are risky since they are sold by intermediaries. Deposit brokers do not go through any federal or state licensing or certification procedures.

Critics of CDs point out there is a risk inflation could outpace your predicted earnings and income tax is not figured in with the estimate return. You should consult with a financial expert to determine the actual estimate of earnings you can expect.