Understanding Certificate of deposit; What can it do for you?

What is a Certificate of deposit(CD)?

Certificate of deposit is a savings account where you deposit a specific amount of money for a specific amount of time and in exchange, you earn interest at a predetermined rate. They are offered by banks, credit unions and other financial institutions.

How do Certificate of Deposits work?

Opening a CD is similar to opening any standard bank deposit account. The difference is that you will not be able to access the money you deposit for a specific period of time and that there are penalties for early withdrawal as specified in the terms of the CD.

Principal

This is the initial amount of money you deposit when you open a CD. It is the basis upon which the interest is calculated. Some CDs may have a minimum deposit requirement, others may not.

Term

This is the length of time it takes the CD to mature. It can vary from a few months to several years. During this time, you cannot withdraw the funds from the CD without incurring penalties. The funds are considered locked.

Penalties

These are imposed when you withdraw funds from the CD before it reaches its maturity date. They are in place to discourage early withdrawals and also compensate the financial institution for the lost interest. These penalties may include:

1. Forfeiture of interest earned: A percentage of the total interest earned may be deducted.
2. Fixed penalty fee: You may also be required to pay some money predetermined at the time of the CD purchase.

Interest rates

The interest rates on the CD are fixed. It is determined at the time of purchase and remains constant throughout the term of the CD.

Maturity of the CD

At the end of the term, the CD matures. You can choose to;

1. Withdraw the principal along with the accumulated interest.
2. Roll it over into for another term. This means that the principal and accumulated interest is reinvested into a new CD with a new term and potentially a new interest rate.
3. Make changes to the CD. This could include adding additional funds, changing the term or adjusting the interest rate depending on the terms and conditions of the issuing institution and the specific CD.

Some CDs may have an automatic renewal feature. If you do not take any action upon maturity, the CD is automatically renewed for another term with the same terms.

FDIC Insurance

Certificates of deposit are backed by the Federal Deposit Insurance Corporation (FDIC). FDIC insurance provides protection to depositors. If the bank were to fail or facing some financial difficulties, the FDIC would step in and reimburse you up to the maximum coverage limit which is currently set at $250,000.

Benefits of Certificates of Deposit

1. Fixed interest rates

This can be advantageous in the following ways;

• Predictable returns: You can accurately calculate how much interest you will earn. This provides you with a clear understanding of your potential returns which is helpful for financial planning purposes.
• Protection against decreasing interest rates: Even if interest rates decrease during the term of the CD, you will continue to earn the higher fixed rate agreed upon at the time of purchase.

2. Specific term

CDs discourage impulsive withdrawals. This is beneficial if you are saving for a specific financial goal like a down payment on a home or your child’s education.

3. Safety

FDIC insurance helps mitigate the risk of losing your deposited funds in case of a
bank failure.

4. Higher interest rates

CDs offer higher interest rates compared to regular savings accounts especially for longer term CDs and those with larger deposit amounts.

Choosing the best Certificate of Deposit that fits your needs

1. Interest rate

This is one of the key factors that determines the potential earnings of your principal amount. Higher interest rates result in higher returns. Different financial institutions may offer different interest rates.

Comparing rates allows you to identify CDs which are more competitive and can potentially provide higher earnings.

2. Term length

Longer-term CDs offer higher interest rates but they also require a longer commitment of funds. On the other hand, shorter-term CDs have lower interest rates but they provide you with more flexibility in terms of access to your funds. The term length you choose should align with your financial goals and liqudity needs.

3. Insurance

FDIC insurance provides protection for your CD investment in case the financial institution fails. Verify that the institution offering the account is FDIC-insured. Understand the coverage limits and terms to ensure that your funds are protected in the event of a bank failure.

4. Penalties

Given that CDs have penalties for early withdrawal, it is important to know what they are so that you can plan accordingly. If you think you may need to access your funds before the CD matures, consider other types of accounts that offer more flexibility like amoney market account or high yield savings account.

However, if you can leave your funds untouched an agreed-upon term, a CD can be a useful savings tool that allows you to earn interest on your deposited funds.

Disadvantages of Certificates of Deposit

1. Fixed interest rates

Fixed interest rates means that you will not benefit from potential increases in market interest rates during the term of the CD. You may miss out on other investment opportunities that offer potentially higher returns.

2. Penalties

Early withdrawal penalties can result in forfeiture of interest earned or a fixed fee.

3. Tax implications

Interest earned on the CD is subject to federal and state income taxes which may reduce the overall returns on the earned interest.

4. Fixed term

This can be frustrating if you need to access the funds for an emergencies, short-term needs or unexpected expenses.

5. Lower returns

While CDs provide a stable and predictable rate of return, they offer lower returns
compared to other investment options such as stocks, mutual funds or real estate.
For investors who are seeking higher returns, CDs may not be the best option.

6. Inflation risk

If the inflation rate exceeds the interest earned on the CD, the purchasing power of
the invested funds may erode over time.

Certificate of deposits can be a useful tool for individuals who want to set aside money for a specific period of time and earn a fixed rate of return with relatively low risk. They offer fixed interest rates, safety, a fixed term and can provide a disciplined approach to saving.

However, they may not be ideal if you need immediate access to your funds or seeking higher returns. They also have penalties for early withdrawal and potential opportunity costs if the interest rates rise during the term of the CD.

Carefully consider, your financial goals, the terms, interest rates and fees associated with CDs before investing in them. You could also consult a financial professional to see if this is the best option for you.