CD's: Certificates of Deposit
What are Cd's?
• Cds, or certificates of deposits, are financial products commonly offered to consumers in the United States by thrift institutions, credit unions or banks. Cds share a number of characteristics with a common savings account; they both are insured by the Federal Deposit Insurance Corporation and thus, virtually risk free. That being said, CDs are somewhat different from a savings account in that a certificate of deposit has a specific fixed term (typically three months, six months or one to five years) and attached with a fixed interest rate.
• Similar to other fixed-income investment products, a CD is held until maturity, at which time the money placed in the CD may be withdrawn with the attached interest. As a result of the limited to no risk of CDs, the interest rate attached is significantly less than other fixed-income instruments.
• In exchange for holding the money on deposit for the specified term, a financial institution will typically grant higher interest rates than they would for accounts where the money may be withdrawn on demand—i.e. a savings account. Although fixed rates are common with a certificate of deposit, a number of CDs are attached with variable rates.
Characteristics of Interest Rates:
• The following characteristics of interest rates act as guidelines for investors in CDs:o A larger principal payment will typically receive a higher interest rateo A longer term will typically receive a higher interest rate, except in the case of an inverted yield curve present prior to a recessiono Smaller institutions well tend to offer higher interest rates than larger oneso Personal CD accounts will typically receive higher interest rates than CD accounts of businesseso Banks and Credit Unions that are not insured by the FDIC or NCUA will typically offer higher interest rates to entice investment
How does a CD work?
• CDs will typically require a minimum deposit (the majority of CDs will pay a higher interest rate for larger deposits). The consumer who opens a CD will receive a paper certificate; this document will affirm the characteristics of the CD, including the maturity date (date at which the money can be redeemed), the attached interest rate and the amount of deposit.
• An investor may withdrawal their principal prior to the CDs’ maturity date but such a maneuver will be subject to penalty. For example, if an individual redeems his or her 5-year CD prior to the maturity date, they will lose six months’ interest. These penalties ensure that is in the holder’s best interest to wait till the CD matures.
• Although CDs offered a guaranteed return on investment the percentage of interest is drastically low. As a result of this minimal return, the profit often barely climbs past inflation levels.
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