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What Is A CD?

A certificate of deposit is a type of savings account where a bank or credit union agrees to pay an above average interest rate for a fixed period of time. The reason why the interest rate is higher than a traditional savings account is because canceling a certificate of deposit prior to its maturity date will normally incur penalties. In this way the financial institution has the benefit of knowing it will have full access to the funds for the term of the certificate of deposit and the customer knows they will get an above-average rate of return as a result.

Due to a certificate of deposit status as a savings account it is afforded the same protections as other types of accounts by the Federal Deposit Insurance Corporation. As most consumers know the FDIC insures demand deposit accounts up to $250,000 per account owner. This is the primary reason why a number of consumers choose to invest in certificates of deposit instead of purchasing stocks or bonds. They like knowing that their money is earning more interest than by sitting in a traditional savings account but that it is also protected should the bank or credit union become insolvent and go out of business. This is why CDs have become popular in the last few decades and are considered viable investment alternatives for a large portion of the population.

The structure of a CD offered by financial institutions is usually in increments of three months, six months, 12 months and then from 3 to 5 years. Most CDs also have minimum requirements for the amount that must be invested normally starting at $1,000. That's not to say that a bank or credit union can't offer an 18 month CD with a minimum of $500 but just that it is less likely. The larger the amount initially invested with a longer term will normally result in significantly higher rates of return. An example would be a $100,000 CD purchased for five years which could earn 10 times as much interest as a traditional savings account.

Some of the variations in certificates of deposit can include the ability to add to an existing CD balance if the bank or credit union allows it as well as having the CD automatically roll over into a new term after the original reaches maturity. One technique many consumers will do since CDs tie up funds for the length of maturity is to have revolving certificates of deposit on monthly schedules. To ensure funds are always available without penalty some investors will purchase six 6 month CDs from January to June and then have them roll over at maturity. This ensures that at least some funds will be available penalty free while still earning higher rates of interest.

Some additional variations in certificates of deposit have become available in recent years to allow for more flexibility and to attract new customers. One of these types is called a liquid certificate of deposit which allows investor to withdraw some money without incurring penalties. While this type of CD may pay less in interest than a more traditional CD it allows for flexibility to have some funds available immediately if it becomes necessary. Another type of new CD is referred to as a "bump up" CD. If a consumer purchases a five-year CD and two years into the term interest rates increase significantly and the bank is now offering the even higher rates then this would allow for a one-time option to bump up to the new rate. Of course interest rate trends are unpredictable by nature so this type of CD would offer a below average rate initially on the hope that rates trend upward later on. If interest rates stay relatively flat for the length of the CD then the consumer would have made less in interests than if they had gone with a more traditional option.

Certificates of deposit are an additional investment option for consumers who want to preserve principal and maintain FDIC protection while earning slightly more interest on their deposits. The trade-off is a little less flexibility in gaining access to funds but if the money was sitting in a savings account anyways then sometimes it is more beneficial to purchase a CD. Any consumers with extra financial resources might consider purchasing a certificate of deposit to diversify their holdings and make their money work for them.