Money Market: Certificate of Deposit (CD)
A certificate of deposit (CD) is a time deposit with a bank. Time deposits may not be withdrawn on demand like a check account. CDs are generally issued by commercial banks but they can be bought through brokerages. They bear a specific maturity date (from 3 months to 5 years), a specified interest rate, and can be issued in any denomination, very similar to bonds.
CDs offer a slightly higher yield than T-Bills because of the slightly higher default risk for a bank, but overall the likeliness of a large bank going broke is pretty slim. Of course, the amount of interest you earn depends on a number of factors such as the current interest rate environment, how much money you invest, the length of time, and your specific bank. While nearly every bank offers CDs, the rates are rarely competitive, so it’s important to shop around.
An fundamental concept to understand when buying a CD is the difference between annual percentage yield (APY) and annual percentage rate (APR). APY is the total amount of interest you earn in one year taking into account compound interest. APR is simply the stated interest you earn in one year, without taking into account compounding.
The difference results from when interest is paid. The more frequently interest is calculated, the greater the yield will be. When an investment pays interest annually, its rate and yield are the same. But when interest is paid more frequently, the yield gets higher. For example, say you purchase a 1-year, $1,000 CD that pays 5% semiannually. After 6 months, you’ll receive interest payment of $25 ($1,000 x 5 % x .5 years). Here’s where the magic of compounding starts. The $25 payment starts earning interest of its own, which over the next 6 months amounts to 62.5 cents ($25 x 5% x .5 years). As a result, the rate on the CD is 5 percent, but its yield is 5.06. It may not sound like a lot, but compounding adds up over time.
The main advantage of CDs is their safety and knowing the return you’ll receive. You’ll generally earn more than in a savings account, and you won’t be at the mercy of the stock market. Plus, in the U.S. the FDIC guarantees your investment up to $100,000.
There are two main disadvantages to CDs. The returns are paltry and your money is tied up for the length of the CD. You can’t get your money out without paying a harsh penalty.