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Certificate of Deposit (CD)



Definition

A Certificate of Deposit (CD) is a type of time-based savings account offered by banks and credit unions. The investor deposits a specified sum of money for a predetermined period, during which interest is accrued at a fixed rate. It can only be withdrawn at the end of the term or ‘maturity date’ , often with a penalty for early withdrawal.

Phonetic

The phonetic pronunciation of “Certificate of Deposit (CD)” is:Certificate – /sərˈtɪfɪkɪt/of – /əv/Deposit – /dɪˈpɒzɪt/ (CD) – /ˌsi: ˈdi:/

Key Takeaways

  1. Certificates of Deposit are a type of time deposit: A CD is a financial product that you can purchase from a bank, credit union, or online financial institution. It’s a form of timed deposit where you agree to leave a sum of money in the account for a certain period of time, known as its term, which typically ranges from a few months to several years.
  2. They typically offer higher interest rates than traditional savings accounts: Due to the nature of CDs requiring customers to commit their funds for a specified period of time, banks and financial institutions usually offer a higher annual percentage yield (APY) in comparison to regular savings accounts. This makes CDs a lucrative option for individuals looking for low-risk investments.
  3. Early withdrawal is often penalized: If you withdraw your funds from a CD before its maturity date, you’ll likely face an early withdrawal penalty, which is typically a portion of the interest earned. This is a downside to CDs and something to consider before opening one, especially if you might need access to the cash before the term ends.

Importance

A Certificate of Deposit (CD) is significant in the realm of business and finance as it serves as a safe and secure form of investment. This short-to-medium-term investment tool is offered by banks and credit unions, typically involving a fixed principal amount deposited for a defined period, at a predetermined interest rate. The relevance of a CD is underpinned by its ability to provide stable returns with minimal risk, unlike fluctuating stock or bond markets. It permits a more predictable income stream, adding a degree of certainty and stability to an investor’s portfolio. Without such stable components in the financial plan, the investor could potentially face higher risk and volatility. Therefore, CDs play an essential role in both individual and institutional financial planning.

Explanation

The primary purpose of a Certificate of Deposit (CD) is to offer individuals a safe, risk-free method to save and grow their money over a specific period. It serves as a medium of investment where individuals deposit a certain sum of money with a financial institution like a bank or a credit union. This mechanism of saving provides a higher rate of interest than regular saving accounts, making it an attractive option for those seeking steady, predictable returns without exposure to the machinations of volatile markets. By agreeing to leave their money untouched in the CD for a specified timeframe, individuals are rewarded with favourable interest rates. Moreover, Certificate of Deposits serves to ensure liquidity management and fiscal planning for both, the financial institution and the depositor. For the banks, it allows them to securely have funds at their disposal for a certain period, aiding in maintaining their liquidity and planning their financial resources. On the other hand, customers can choose CDs with varying maturities as per their monetary goals, making it an excellent vehicle for both short-term and long-term savings strategies. The pre-determined interest rate provides certainty of returns, and hence, CD is not only a savings tool but also a financial planning instrument.

Examples

1. Saving for a Car: Suppose someone plans to buy a new car within 2 years. To ensure they have sufficient funds, they decide to invest in a 2-year Certificate of Deposit (CD) at their local bank. Their deposit is insured up to $250,000 by the FDIC and in addition, the bank offers a fixed interest rate more generous than a typical saving account. After the 2-year term, they can liquidate the CD, now worth more than the initial deposit, to make the vehicle purchase. 2. Education Fund: A couple has just had their first child and decide to start saving for the child’s college education. They opt for a long-term CD, locking in a favorable interest rate for 18 years. Since CDs are safe and insured investments, they can be confident that the funds will be available when their child is ready for college. 3. Business Investment: A small business owner has just received a generous profit from his business but doesn’t have immediate plans for expansion. Instead of letting the money sit idle in the bank with low-interest rates, they choose to invest in a 6-month or 1-year CD, knowing they can count on the predictability of a fixed return at the end of the term. This way, the business owner can grow his savings with minimal risk.

Frequently Asked Questions(FAQ)

What is a Certificate of Deposit (CD)?
A Certificate of Deposit, or CD, is a type of financial product offered by banks and credit unions. It is a form of time deposit where money is given to the institution for a fixed period of time, and the depositor receives a set interest rate.
How does a CD work?
When you open a CD, you agree to keep your money in the account for a specified period, known as the term. During this time, the bank pays you interest. At the end of the term, you get your initial deposit back plus any accrued interest.
Are CDs a safe investment?
Yes, CDs are considered a safe investment as they are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000.
Do CDs have fixed or variable interest rates?
CDs commonly come with fixed interest rates, which means the rate is set at the beginning and doesn’t change for the life of the CD.
Can I take my money out before the end of the CD term?
Yes, but usually you will face an early withdrawal penalty. The details of the penalty should be included in the terms and conditions of the CD.
How is the interest on a CD calculated?
Interest on a CD is usually compounded daily or monthly. The compounding frequency impacts the annual percentage yield (APY) for the CD.
How does a CD differ from a Savings account?
The primary difference between a CD and a Savings account is liquidity and interest rates. CDs generally offer higher interest rates, but your funds are locked in for a set period. A savings account offers lower interest rates but allows for regular transactions.
How are the interest earnings from a CD taxed?
Interest earned on a CD is considered taxable income by the Internal Revenue Service and is taxed at your marginal tax rate.
Can I add more money to a CD?
Typically, you cannot add funds to a CD once it’s been opened. However, some banks do have certain CDs called add-on CDs that allow you to add funds.
What happens when a CD matures?
When a CD matures, you have several options. You can withdraw your money, renew the CD for another term, or possibly roll it over into a different type of account. Remember to always consult with a financial advisor or a bank professional when making financial decisions or investing in CDs.

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