What they are
Certificates of deposit are like the offspring of bonds and savings accounts. CDs are issued by banks or credit unions. They're insured by the Federal Deposit Insurance Corp. or the credit union equivalent known as the National Credit Union Administration. Like bonds, they sport a coupon, or interest rate, and a maturity date.
The interest rate will typically be slightly higher than that of a savings account due to the time element on a CD.
How they work
Certificates of deposit are also called time deposits; you give the bank your money and they pay you a fixed rate of return for a specified amount of time. At the end of the term, you get your money back plus interest.
If you need to access your money before the CD matures, you will likely be hit with an early withdrawal penalty.
Advantages and disadvantages
Unlike many investments, CDs are easy to understand and they're extremely accessible. Anyone can walk into a bank and buy one. They are also extremely safe. There are two ways to lose money in a CD: through a bank default or an early withdrawal.
Because most CDs issued by American banks are insured by the FDIC or NCUA, CD investors can rest assured their CDs are protected from a bank failure -- for up to $250,000.
An early withdrawal by the investor is much more likely to occur than a bank failure, even these days. Savers should investigate the early withdrawal penalty before investing their savings. It could cost more to break the CD than the investment would have ever earned in interest.
CDs are great for short-term savings or as part of an overall strategy. What makes them unattractive, despite their safety, is the low yield. In today's rate environment CD rates are no match for inflation.
Just to keep up with an inflation rate of 2 percent, $100 invested in a five-year CD today would need to earn about $10.
According to a recent rate survey by Bankrate, the average five-year CD yield is 1.19 percent. An investor would gain $6.09 after five years on a $100 investment.
"For short-term savings, a CD is very appropriate. But I don't think a CD is a very productive long-term investment at all," says Lance Scott, president of Bay Harbor Wealth Management in Baltimore.
"A lot of older investors find themselves in the CD trap. They will be in a CD for a short period of time, and then before they know it they've rolled it over for years," Scott says.
However, some yield is better than nothing. Investors may find it more worthwhile to take the paltry yield on a one- or two-year CD over staying in cash for a portion of their portfolio.
Hopwood suggests keeping some money in CDs "just because there is a penalty for keeping it in cash right now -- cash is basically yielding zero."
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