A Certificate of Deposit (CD) is a saving certificate with a fixed maturity date, specified fixed interest rate and can be issued in any denomination aside from minimum investment requirement. CDs are generally issued by commercial banks, credit unions and thrift institutions. A CD restricts access to the funds until the maturity date of the investment. The fixed term of the CD can be in one, three or six months or one to five years. Whereas the interest rate usually higher than the common bank saving. The interest offered depends on various factors such as current rate interest, the amount of money invested, the length of the time and the bank chosen.
A CD is a promissory note and it has time deposit that restricted holder to withdraw funds. It is typically issued electronically and can be renewed automatically upon the maturity of the original CD. The entire principal, as well as interest earned, is available for withdrawal when the CD matures.
Although it is possible to withdraw money before the maturity date, usually it entails a penalty. In general the longer the maturity date, the higher interest rate is. The reason is the operation of CD works based on the premise that the holder gives up the liquidity for a higher return. The longer the period, there is more uncertainty and risk associated. Because the individual abstains from the opportunity to use the money for the specific amount of time, thus it compensated by earning more interest.
Before deciding to invest in CD, when buying a CD examine the difference between annual percentage yield (APY) and annual percentage rate (APR). APY is the total amount of interest earned in one year, taking compound interest into account. APR is simply the stated interest you earn in one year, without taking compounding into account.
The difference occurs when the interest is paid. The principle is the more often interest is calculated, the greater the yield will be. When an investment pays interest yearly, the rate and yield are the same. However, when the interest is paid more often, the yield gets higher. For instance, an investor purchases a one year CD with $2000 with interest rate 5% semi-annually. After six months, the interest is $50 ($2000×5%x0.5 years). This $50 starts earning interest on its own, which for the next six months amount to $1,25 ($50x5x0.5 years). From this, it can be concluded that with the rate of 5% CD the yield is 5.06%. It seems not much but if compounding over the time it adds up.
CDs are relatively safe, stable and it has the advantage knowing the return ahead of time. In general, compared to the saving account, the interest is slightly higher. In addition to that, especially in the US, CDs are protected and guaranteed by the Federal Deposit Insurance Corporation up to $100,000. Despite the benefits, there are two main disadvantages to CDs. First of all, the returns are insignificant compared to many other investments tool. Furthermore, the money is freeze for the length of the CD and difficult to get unless paying the penalty.