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What is a Certificate of Deposit and How Does it Work?

Last Updated: 04. June 2019

What Is A Certificate Of Deposit?

A Certificate of Deposit (CD) is an account you put money into for a fixed period of time, in order to earn a fixed rate of return.  Just like with savings and checking accounts, if your CD is held with a bank you are insured up to $250,000 by the FDIC, and if it is held with a credit union, the NCUA insures your account for the same amount.  As money invested in a certificate of deposit is insured, generally CD’s pay a lower rate of interest than other types of investments which are not guaranteed against loss.

How a Certificate of Deposit Works

A certificate of deposit has a fixed period of deposit, unlike a savings or money market account.

This means that you can’t take your money out of the CD before the end of the agreed upon time frame, unless you are willing to pay a stiff penalty.   While there is technically no legal limit to the penalty for withdrawing money invested in a certificate of deposit early, typically most banks set the penalty at 3 to 6 months of earned interest for an early withdrawal.  Because you agree to tie your money up for a set period of time, certificates of deposit generally pay a higher interest rate than savings and checking accounts.

Certificate of Deposit (CD)
A Certificate of Deposit (CD) locks up your money for a fixed amount of time for a guaranteed return.

How you earn interest on a certificate of deposit

While different financial institutions (banks and credit unions) will offer different rates on the same certificate of deposit, there are two general factors that determine how much interest you will receive:

  1. How long you are willing to tie your money up for
  2. How much you are willing to invest.  Generally, the longer you are willing to tie your money up and the more you have to invest, the higher the interest rate you will receive on your certificate of deposit.

There are a range of options for CD lengths or durations. Some of the more common types of CD’s are 21 days, 1, 3, 6, 9 months and 1, 2 , 3, 5 and 10 years.

Factors to consider when placing money in a Certificate of Deposit

In addition to interest rate, duration of the CDs, and withdrawal penalties, there are few other factors to consider when buying a certificate of deposit.

  1. Do you have to wait until the CD matures (the lock-up period for you money is over) to receive your interest, or will you be paid throughout?
  2. Does the bank have the ability to call the CD?
  3. Does the bank have the right to give you back your money and stop paying any more interest?
  4. What happens when the fixed term of the certificate of deposit ends? Does the bank automatically re-new the CD at current market rates or send you the money?
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David Waring

David Waring was the founder of LearnBonds.com and has been a major contributor to the extensive library of investing news and information available on the site. Until the launch of Learnbonds.com in late 2011 there was no single site on the internet catering exclusively to the individual bond investor. This was true even though more individuals own stocks than bonds. Learn Bonds was launched to fill that gap.

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