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How do CDs (certificates of deposit) work?

Details on Certificates of Deposit
Laddering your CDs can help you invest while maintaining liquidity.
Laddering your CDs can help you invest while maintaining liquidity.
iStockphoto/Alexandr Tovstenko

­Although CDs grow faster than savings accounts, they're just as safe. That's because they're protected with the same insurance as other bank accounts are -- under the Federal Deposit Insurance Corporation (FDIC). As long as you're with an FDIC-insured bank, at least a portion of your funds is protected in case the bank goes under. Typically, all of your funds up to $100,000 would be refunded. So, if you exceed this amount, you should consider spreading your wealth around. Putting your excess funds in a different bank will make sure they're all insured.

Also like savings accounts, CDs earn compound interest. This means that as your funds get interest added to them, the next interest is taken on the total amount of your original funds plus interest previously earned. This means that, although the interest percentage remains constant, the amount of interest added increases each time.

Not all CDs are created equal -- you should shop around before deciding on what bank to use. Some banks have heftier early withdrawal fees than others, for instance. Before you research specific banks, get familiar with some of this CD jargon to understand what the policy entails. One important term is annual percentage yield (APY).This refers to the rate of return you earn in a year accounting for compounded interest. It depends on how often interest is added. This is different from annual percentage rate (APR), which is the simple interest rate at the outset of a year.

­Not everyone haphazardly stuffs funds into one CD, however. Some people approach CD investments with a distinct strategy. One such strategy is CD laddering. This means dividing up your funds and investing different amounts into different CDs. The different CDs have varied maturity dates -- one might be one-year, another two-year and the last in a three-year policy. After the first expires, the investor puts the funds into the three-year CD, which now has only two years left on it and a higher interest rate. When the two-year expires, the investor can again put it in the three-year CD. Laddering has the advantage of giving you better liquidity with the option of holding the early-maturing funds rather than reinvesting.

If you're afraid of relinquishing your access to your funds for the period of a CD, you could always go with a money market account instead. This kind of account may not earn as much interest, but you'll have more -- although somewhat limited -- access to the funds.

But, of course, experts always advise diversifying your portfolio with multiple kinds of investments. Learn more about CDs and investing with the great links on the next page.