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What are Certificates of Deposit (CDs)? Here's how they work

At a glance:

  • What are CDs?

  • Small-savings CDs

  • Negotiable CDs

  • Specialty CDs

  • Summary of CDs

Banks issue short-term, interest-bearing certificates called certificates of deposit (CDs). Credit unions also do, but their certificates of deposit pay dividends rather than interest. Credit union certificates may be called certificate accounts, share certificates, or just certificates.

Certificates are timed deposits. If you place money into one, you must leave it there for a specific number of days to get a stated earnings rate (although some CDs have variable rates). You will receive both principal and interest/dividends at maturity.

CDs have two advantages over most other investments: You know exactly how much will be earned, and you know exactly when the money will be available to you. Certificates are popular among people who like their investments low-risk and straightforward.

Many advisors also consider CDs suitable tools for diversifying portfolios. While investors may devote some parts of their portfolios to growing in value, they often devote other parts to safety of principal. CDs come in handy for this.

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What are CDs?

Certificates of deposit (CDs) are timed deposits offered by many financial institutions. Credit union certificates may be called certificate accounts or just certificates. They come with some stringent rules.

Because your money is expected to stay on deposit until maturity, you may be assessed a penalty if you withdraw your money from it early. Usually, the penalty is three to six months' interest (for banks) or dividends (for credit unions).

CDs are insured

Banks and credit unions sell most CDs. The Federal Deposit Insurance Corporation (FDIC) provides insurance for bank CDs up to $250,000 ($250,000 for retirement plan accounts) per depositor. Credit union certificates are insured for the same amounts by the National Credit Union Share Insurance Fund (NCUSIF). Certificates are not insured separately (unless they are IRA certificates).

Brokerage firms also sell CDs. They typically look for those with the highest rates and make them available to their clients. However, investors will pay a fee for this service—usually 1% or so of a CD's yield. All expenses should be considered prior to signing up for the CD with the highest stated rate because it might not have the highest return after fees are deducted.

About the earnings on CDs

Whereas the issuer sets most CD rates, some rates rise with interest rates. These are called rising-rate CDs.

Generally, the more money deposited into the CD and the longer it stays there, the higher the rate paid. Any interest or dividends earned are taxable.

Rate vs. yield

If you see CD returns quoted for both rate and yield, remember that these are two different things. The rate is stated interest/dividends that the CD pays. The yield is what the investor would receive if left on deposit for 365 days and is the compounded rate of return. Compounding means that earnings are paid on the earnings earned.

For example, if the rate is 5.51%, the CD's annual percentage yield may be 5.65% instead. Financial institutions may compound earnings daily, monthly, quarterly, semi-annually, or annually. Be sure to compare both the rates and yields when comparing investments.

Small-savings CDs

Certificates of deposit for amounts less than $100,000 are called small-savings CDs. They were created so that small investors could participate in the certificate market.

Uses of small-savings CDs

Most of them are used like savings accounts, although the length of their maturities and amount of money invested determine their rates. The minimum deposit, the interest/dividend payment schedule, and the methods of compounding differ from institution to institution. Be sure to check these factors out carefully prior to investing.

Numerous individual types of certificates serve different purposes within the category of small-savings CDs. For example, for a minimum deposit of $10,000, you can buy Treasury-rate CDs. The weekly rates on six-month Treasury bills determine their rates.

Small-savings CDs might be a good vehicle for emergency funds or for saving for short-range (less than three years) financial goals.

Negotiable CDs

Negotiable certificates of deposit are issued in denominations over $100,000 and sold on the open market.

They are a type of money market instrument. The depositor of a negotiable CD is allowed to negotiate the interest or dividend rate with the financial institution.

The secondary market is where investors can sell their CDs to other investors before maturity if they need cash. These CDs must be $1 million or more in value to be traded.

Negotiable CDs have maturities ranging from 14 days to more than one year. Their rates are closely tied to the going rate of US Treasury bills. Along with other CDs, they are the only interest- or dividend-bearing money market instruments, and they are considered safe and liquid. They can be quoted on the NASDAQ, but they must have a minimum maturity of 14 days.

Specialty CDs

Here are some of the most popular variations on certificates. This list is by no means exhaustive.

Credit union share certificates

Credit union share certificates (or certificate accounts) are negotiable certificates issued by credit unions.

Stock-index CDs

Stock-index CDs have rates based on the Standard & Poor's 500 Stock Index. For the period during which the CD is held, the issuing financial institution takes the average percentage increase in the S&P 500 level and doubles it, then pays this figure out as interest or dividends. Thus, if the S&P 500 grew by 3.5%, the interest/dividends paid would be 7%.

Add-on CDs

Add-on CDs are those that allow the investor to deposit money into them after they have been set up.

Variable-rate CDs

Variable-rate CDs are instruments whose rates move up or down according to changes in interest rates. They were created to keep up with volatile short-term interest rates. A third party sets new rates every 30 days.

Discount CDs

Discount CDs are sold for less than their face values. When they mature, the investor receives the face value. The difference between the face value and the discount price is treated as earnings. For example, a $500,000 CD can be sold for $475,000. When it matures, the investor will receive $500,000, and the $25,000 difference will be treated as earnings.

Summary of CDs

Certificates of deposit (or just "certificates") have been popular among investors for a long time. Many risk-averse investors find CDs appealing. On top of their relative safety, CDs also provide competitive returns.

Credit unions and banks have made available a variety of features to suit your needs, such as varying maturities, variable interest or dividend rates, and small deposit requirements. Compared to many other investments, CDs are simple and easy to understand.

CDs are available in varying maturities as well as with rates based upon different market measures. You can buy them from your local credit union, bank, or investment broker. Compare rates, maturities, and methods of payment when shopping for certificates of deposit.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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