How Do Certificates of Deposits (CDs) Work?

One of the safest investment vehicles at your disposal is a certificate of deposit (CD). This is a time deposit, a financial product that is commonly offered to consumers by banks, thrift institutions, and credit unions. If you want to be at the least-risk zone, a CD might be the right investment option for you. A CD is similar to a savings account in the bank - it is insured and virtually free of risks. However, it is different from a savings account in the sense that it has a fixed, specific term (usually varying between three months and five years), and more often than not, a fixed rate of interest. However, the money you earn with a CD is more than what you get with a savings account. The banks expect that the greater interest rate will prompt you to keep your money in the CD for a specified period of time, giving them some certainty and ability to use the money for other purposes.

Getting a CD is quite simple. Just inform your bank or credit union that you wish to purchase a CD. You will be required to fill in a simple form with some disclosures and they will move the money into your CD. You may get a passbook or paper certificate, but a certificate of deposit presently consists simply of a book entry and an item shown in your periodic bank statements with no need for "certificate."

At most institutions, you can have the interest periodically mailed as a check or transferred into a checking or savings account according to your instructions. This means reduction in total yield because there is no compounding. Some institutions allow you to choose this option only at the time you open your CD. Normally, institutions mail a notice to you shortly before the CD matures asking for directions. The notice generally offers you the choice of withdrawing the principal and accumulated interest or "rolling it over" by depositing it into a new certificate of deposit. A "window" is usually allowed after maturity in which you can cash in the CD without penalty. If you don't give any directions, they will just "roll over" the CD automatically, once again keeping your money for a period of time.

In normal practice, certificate deposits require a minimum deposit, and many institutions offer higher rates for larger deposits. In the United States, the most attractive rates are usually offered on "Jumbo CDs" with minimum deposits of $100,000. However, in view of the fact that some investors do not want more in the account than is covered by FDIC insurance, some institutions have lowered the amount of minimum deposit to $95,000. You can also find some institutions that do the opposite and offer lower rates for their "Jumbo CDs".

If you withdraw before maturity, you are usually subject to a substantial penalty. For a five-year CD, you are likely to lose six months' interest. These penalties usually discourage CD holders from withdrawing their money before maturity, unless they have any alternative investment option with significantly higher return or have an urgent and serious need for the money.