| Many people have heard of certificates of deposit, CD's, but may not fully understand what they are or how they work. You can purchase a CD right from your local bank, but before you do it's important that you have a firm grasp on just exactly how they work.
CD's are similar to regular savings accounts and are a good choice for investors who are risk adverse. Like a savings account your CD can be federally insured so they are a very safe form of investing. Unlike a savings account they will typically pay a fairly competitive interest rate.
When purchasing a CD you can determine how long of a term you want. You can choose from a few months up to 10 years, or more. The amount of interest you earn can be variable or fixed, though it will usually be higher with a higher deposit amount and/or a longer term.
It's important that you get all the information regarding the maturity date in writing. This can protect you against accidental, or not so accidental, misunderstandings when your CD reaches maturity.
The reason CD's pay higher interest than a regular savings account is because you are agreeing to let the bank 'borrow' your money to lend to others. That's the way the bank makes money. They lend money for mortgages and car loans, charge interest on those loans and part of that interest they earn is paid to you for the use of your money. Since you are agreeing to let them use your money for the full term of your CD they can calculate how much they will likely earn using your money and they will pay you an interest rate based on that amount.
It's for this reason you will incur significant penalties if you cash out your CD prior to it's maturity date. Since the bank can't use your money for as long a period as they originally planned, they won't be able to make as much money... and neither will you.
When you have a CD that is getting near to it's maturity date you will receive a letter from your financial institution reminding you of that fact and asking you to let them know what you want to do. At that point you can take your money out, with no penalty, or you can roll it over into another CD or other types of investments.
When you first sign up for your CD you may have the option of how you want your interest to be paid. You can often have it paid to you monthly, or semi-annually. Just remember, that if you decide to receive interest payments during the course of your CD's term, it will likely lower the overall return on your investment. Why? Because if you let the interest remain in the account it will compound. If you take interest out, you are eliminating the compounding effect so you will earn less interest. Make sure you ask what your options are when you sign up since you won't be able to change your mind afterwards.
Certificates of deposit can be a great way for investors to make money safely. But it's not without risk, the biggest risk is a lack of knowledge. Before you sign on the dotted line make sure you find out the answers to the points I've listed above, and any other questions you can think of. |