If you’re looking to keep your funds safe for a project in the near future, a certificate of deposit might be your best option. Certificates of deposit are as safe as regular savings and money market accounts but allow you to earn higher returns than those.
This article discusses certificates of deposit, their advantages, and how to invest in them.
What is a Certificate of Deposit?
A certificate of deposit (CD) is a financial instrument offered by banks and credit unions to individuals and businesses looking to save a lump sum for a given period. CDs earn interest throughout the fixed term, ranging from a few months to several years.
Certificates of deposit are similar to savings accounts, as they allow you to save money for a specific goal within a specific period. However, unlike savings accounts, you can’t withdraw the funds deposited in a CD until maturity. This loss of liquidity in CDs is compensated by higher interest rates than is obtainable in a regular savings account.
How Does a Certificate of Deposit (CD) Work?
A certificate of deposit is a savings product and works simply like other savings products. When someone opens a CD account, they deposit a lump sum of money and agree on a period of time in which the money must remain in the account. In return for not withdrawing the money within the agreed period, the bank or financial institution pays interest on the deposited amount and guarantees the return of the principal at the end of the CD term.
With the fixed interest rates they offer, investors can easily estimate the returns they will get at the end of the term.
For example, if you invest $10,000 on a CD with a fixed interest rate of 7% for one year, at the end of the period, the bank or financial institution will credit you with $700 in interest plus your principal of $10,000.
Features of a Certificate of Deposit?
Here are some important features that define a certificate of deposit:
Fixed Term
Certificates of deposit have a fixed term or maturity period, which ranges between a few months and a couple of years. During this time, withdrawals from the account are highly prohibited and come with a heavy penalty. The most common terms on CDs are three months, six months, and one year. However, CDs from non-bank financial institutions can have a fixed term that ranges from 1 to 3 years.
Fixed Interest Rate
Most CDs have a predetermined interest rate, which remains constant throughout the tenure. This fixed rate helps you predict the return you’ll get at the end of the term.
However, some CDs have variable rates. This could earn you higher or lower returns due to changes in interest rates.
Principal
The principal of a certificate of deposit is the lump amount you deposit when you open the CD. Many banks and financial institutions set a minimum deposit requirement for their CDs, which varies based on the term and other factors.
Early Withdrawal Penalties
Early withdrawal penalties on CDs usually come as a deduction of a percentage of the interest earned or the entire interest based on the agreement reached.
What Are the Advantages of a CD?
Here are some advantages of a certificate of deposit:
Safety
Certificates of deposit are issued by banks and financial institutions that are insured and supervised by the FCS and other regulatory bodies. Regardless of market conditions, you will receive your interest and principal at the end of the maturity period.
Higher Rates than Savings Accounts
Certificates of deposit pay higher rates than savings and money market accounts, and this is because of the liquidity restriction on them.
Predictable Returns
With the fixed interest rates on CDs, you’re sure of the returns to expect at the end of the maturity period.
Variety of Terms
With the various terms available on a CD, you can choose a CD that meets your financial goals.
Low or No Maintenance Fees
Another advantage of CDs is the low or no maintenance fees attached, which makes the return even more predictable. Unlike savings accounts, where banks charge account and card maintenance, CDs are managed at no cost to the investor.
What are the Disadvantages of a CD?
Here are some drawbacks of CDs you must take note of before investing your money in them:
Lack of Liquidity
Most CDs have a fixed term, and withdrawals before the maturity date come with heavy penalties. This makes them unsuitable for investors who might need access to their cash in case of emergencies.
Opportunity Cost
With a fixed interest rate, you agree to forfeit the opportunity to earn higher interest rates when rates rise.
Inflation Risk
The interest you earn on CDs may not keep up with inflation. This means that when inflation rises above interest rates, the purchasing power of their returns may decrease.
Limited Returns
While they offer guaranteed returns, the interest rates on CDs are often lower when you compare it to stocks, mutual funds, and other high-risk investments.
Early Withdrawal Penalty
Withdrawals before maturity dates are highly prohibited on CDs. If you withdraw your funds from a fixed-term CD, you risk losing the entire interest earned.
How to Invest in a Certificate of Deposit
Here are the steps you can take to invest in a certificate of deposit:
1. Find an Insured Financial Institution
The first step in investing in CDs is to choose a financial institution with a good reputation. Examine the institution’s credibility and ensure they’re insured by the Financial Claims Scheme, the Australian body that insures deposits in financial institutions.
2. Choose the CD Term
Decide on how long you’re willing to lock in your funds. This can be between three months and three years, depending on the financial institution you’re investing in.
Long-term CDs usually have higher interest rates than short-term CDs.
3. Examine the Conditions
Consider other conditions that may come with the CD, such as interest rates, early withdrawal fees, minimum deposit requirements, etc.
4. Deposit Funds
Once satisfied with the CD terms and conditions, you can complete the application and make the needed deposit.
5. Wait Until Maturity
Once the funds are locked in, the only thing left is to wait for the maturity date to make your penalty-free withdrawal. You can also choose to roll it over into a new CD if you don’t have an immediate need for the cash.
Are CDs Safe?
Like savings accounts and money market securities, CDs are one of the safest places to save money. The reason is that most CDs have fixed and guaranteed returns. In addition to that, the federal government insurance covers all deposit products.
Where Can I get a CD?
You can open CDs at any bank (both traditional and online), credit union, or brokerage firm.
How Much Do I Need to Open a CD Account?
Each bank, credit union, or financial institution that offers CDs has its own minimum deposit requirements you must meet to open a CD. This can be as little as $500 or $1000.
But you must understand that the return you get from your CD depends on your investment. The higher your deposit, the higher the return you get.
Do Certificates of Deposit Pay Interest Monthly?
Certificates of deposit interest rates are usually compounded daily or monthly. Most CDs credit interest on a monthly, quarterly, or yearly basis.
Can I Withdraw My CD Interest?
Most CDs don’t allow you to make withdrawals before the maturity date. However, some financial institutions with flexible withdrawal policies allow you to withdraw the accrued interest or a portion of your principal before maturity.
What Happens If I Cash a CD Before It Matures?
If you cash a CD before it matures, you’ll most likely forfeit the interest as a penalty or incur other penalties as agreed with the financial institution.
Conclusion
Certificates of deposit are safe, stable, and guaranteed ways to save your money for a given period, especially if you’re looking to keep a sum of money safe for a project in the near future. Understanding what it means, how it works, and the advantages you can get from it is essential for meeting your financial goals.
Hopefully, this article has given you the needed guidance on how to invest in certificates of deposit and enjoy safe and stable returns.
