How a Certificate of Deposit Works
A certificate of deposit or CD is a short to medium term investment that is made with a bank or credit union. CDs work in a way that is very similar to a traditional savings account with a few important distinctions. In the simplest terms, a CD works like this: you deposit a sum with bank, wait a specified period of time, and then withdraw the sum plus interest.
Banks typically offer a higher interest rate on CDs. The reason for this is that a CD is essentially a loan made by the investor to the bank with the stipulation that the principle sum will not be altered for an agreed upon amount of time, which can be anything from three months to six years. In return, the bank offers a fixed interest rate to the investor based on the length of time the CD is valid for and the amount of money deposited. The bank then generates a promissory note which obligates them to pay back the loan once the CD has matured (the financial term for the date the CD expires). The interest can either be paid out as it accrues or in a lump sum. Although CD interest rates are generally high, the best interest rates are reserved for longer term CDs with larger principle sums.
CDs are considered a safe investment method at they are held at FDIC insured banks or NCUA insured credit unions. The FDIC will insure CDs for up to $250,000. Should the investor decide to withdraw their money prior to the CD reaching maturity, they will only lose the compounded interest, not the original sum. Money can only be withdrawn from CDs after the maturity is reached, so if you may need immediate access to your money but would still like to earn some interest, we recommend a savings account.
There are penalties to withdrawing money from a CD before the agreed upon length of time has passed. The institution that holds the CD should inform investors of these penalties when the CD is purchased. Generally banks will slash interest rates or ask the investor to. The principle sum may or may not be reduced. In addition, a bank can “call” or cancel a CD prior to maturity if necessary.