Advertisement

How do CDs (certificates of deposit) work?

Certificates of deposits are great nest eggs. They take time to mature before they hatch and you can use the funds, but if you're prepared to wait, they'll help your money grow. See more pictures of investing.
iStockphoto

­Do you ever overhear co-workers drop comments like­, "CDs are looking good this year," then you excitedly chime in to say something like, "Yeah -- are you excited about the new Amy Winehouse album?" When you realize that they're talking about certificates of deposit (CDs), you awkwardly back out of the conversation. If this sounds familiar, you're not alone. Most of us don't realize the wide range of investment options that fall between savings accounts and stocks.

CDs are just such an investment. Although savings accounts are a solid first step to securing your finances, they offer paltry advantages beyond that. The interest on them tends to be relatively measly. And, especially when inflation rates get high, your money might be better used in an account with higher interest rates. On the other side of the spectrum, you could invest in stocks. However, your money will encounter more risk in the stock market, and some shy away from such aggressive investments.

Advertisement

Advertisement

­When you've garnered a comfortable stash of funds that you feel you can do without for a while, CDs are a great next step. They offer a higher interest rate than savings accounts, so you can watch your money grow faster. The drawback? You can look but you can't touch -- at least not without a penalty. Unlike savings accounts, a CD has a maturity date, after which you can withdraw your funds in full. If you choose to withdraw before that date, you'll have to pay an early-withdrawal fee.

Say, for instance, you're doing comfortably right now and have a healthy savings stowed away. If you want to see it grow a bit to make sure you can afford retirement or a child's college tuition (and you don't like the idea of trusting a volatile stock market), CDs are a good alternative.

Next, we'll talk specifics about how CDs work.­

 

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.

Advertisement

Advertisement

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.

Related HowStuffWorks Articles

More Great Links

Sources

  • Bruce, Laura. "How to ladder a CD portfolio." Bankrate.com. April 2, 2004. [Nov. 1, 2008] http://www.bankrate.com/brm/news/sav/20010521b.asp
  • Investopedia. "Certificate Of Deposit -- CD." Investopedia. [Nov. 1, 2008] http://www.investopedia.com/terms/c/certificateofdeposit.asp

Advertisement


Advertisement

Advertisement

Advertisement

Advertisement

Advertisement

Advertisement