A certificate of deposit is commonly referred to as a CD, is a secured deposit with a defined maturity date. A certificate of deposit can be purchased from any financial institutions such as traditional banks, online banks, brokerages, and credit unions. The purchaser agrees to deposit a specified dollar amount for a specified period of time in exchange for a higher interest rate. Maturity dates vary on CD’s from 30 days to 5 years. The interest rate earned is higher on long-term certificates of deposit compared to the rate earned on shorter term certificates of deposit.
How A Certificate of Deposit Works
Here’s how it works. A CD, requiring a minimum deposit amount of $5,000.00, from TIAA Bank pays a fixed APY (Annual Percentage Yield) of 2.10% over a one-year time period. Let’s say you deposited $25,000 in this CD. After one year, your investment would have earned you $525.00 in interest. The second year, you would earn $536.03 due to the magic of compound interest.
Connexus Credit Union offers a 2.60% APY over a five-year duration with a $5000 minimum deposit. Therefore, the same $25,000 deposit would yield a $3,471.00 interest premium over a five-year term. That’s far better than 0.10 average APY on a traditional savings account.
CD’s Vs. Savings Accounts
Certificates of deposit have a lot in common with savings accounts. The primary purpose of a certificate of deposit is preservation of capital. Certificates of deposits guarantee the principal about of your investment. They are guaranteed by the FDIC. The Federal Government insures CD funds as well as funds deposited into a local checking or savings account up to $250,000. In addition to the FDIC protection which doesn’t apply to money market accounts, CD’s are safe because they aren’t subject to any market volatility.
However, CDs differ from savings accounts in several ways. For instance, the CD’s interest rate paid out over the duration of the deposit is fixed. Traditional savings account interest rates move up and down throughout the year depending on the interest rate set by the Federal Reserve Bank. Unlike a savings accounts, funds deposited into a CD cannot be withdrawn prior to the maturity date without a penalty. Certificates of deposit have an early withdrawal penalty whereas savings account holders are permitted six withdrawals each month.
CD’s Vs. Stocks
While CD’s play an important role in an investment portfolio, they do not offer the rates of returns that can be offered on riskier investment. Stocks and bonds offer the potential of higher rates of return than that of CDs. The average rate of return in the stock market is 10% based on historical data, not accounting for inflation. However, the higher payout comes with a higher potential risk of loss. It should be noted that despite the duration of time that a CD is held, it is taxed at both the federal and state levels as interest earned rather than at the much lower capital gains rate. Capital gains rates are capped at 15%. For the risk averse investor seeking to protect capital, CD’s are a wise investment.
Investors who are saving for a home or automobile should consider saving money in a certificate of deposit as they are a guaranteed means to generate an interest premium with no risk of loss. CD’s are a good place to maximize your interest earnings while protecting your capital from stock market swings over the short term. You can maintain your liquidity and earn more interest.