THE BASIC PREMISE behind a certificate of deposit is simple enough: You lend a bank your money (as little as $100, but often $1,000 or more) for a specific amount of time (up to five years). In return, you receive a set amount of annual interest on the loan and when the CD contract reaches maturity (when it ends), you get your money back.
How much interest you earn is the key. And that depends on a number of factors -- which bank you use, the prevailing interest rate environment, how much money you invest and how long you lock it up for. Your local bank most certainly sells CDs, but its rates may or may not be competitive.
When buying a CD, there are two terms you need to keep straight: annual percentage yield (APY) and annual percentage rate (APR). The yield is the total amount of interest you will earn in one year. It's expressed as a percentage of what you invest and takes into account the way the bank compounds interest. The rate is simply the interest rate you will earn for that year.
Confused? An example should help. If, say, you earned 1% per month, the APR would simply be 12%. But the APY would be 12.68%. That's because the APY takes into account the compounding effect on the interest you earned earlier in the year.
For conservative investors, the best thing about CDs is that your money is safe. When you purchase one through a bank, your total assets there are FDIC insured for up to $100,000. (If you're going to invest more than that, you should purchase at least two CDs.) At a brokerage house, a single CD may be insured for up to $500,000 through the Securities Investor Protection Corporation (SIPC), or even more through the broker's private insurance.
The other advantage is that you know what's coming to you. You aren't at the mercy of the market, so you can plan accordingly. And you're still earning a whole lot more than if you let that money rot away in a savings account earning a paltry 2%.
There are two big problems with CDs: They have tiny returns and they can lock up your money for the long haul. If you buy a five-year CD in 2001, for example, you can't get the money out any earlier than 2006 without paying a steep penalty. Even on a one-year CD, you might be penalized three months worth of interest. That's why a money-market fund is usually a better alternative. The rate may be slightly lower, but you can withdraw your money whenever you see fit.
Granted, a money market fund is not considered as secure as a CD, but the difference is minimal. According to Peter Crane, managing editor of the IBC Money Fund Report, no money-market fund has "broken the buck" (returned less than the original contribution) in the last 15 years.
But even money funds don't get around the paltry returns issue. While you can reasonably expect a 10% annual return from an stock mutual fund, you're going to earn about half that from a typical CD or money-market fund. Consequently, neither investment should be used for anything other than to park money for a short period of time. If, say, your daughter is heading off to college within a year and you want a risk-free way to keep earning interest on the money you've saved, a CD makes sense. But if she's three years old and you're just starting her college fund, then you need to be much more aggressive.