Certificates of deposit, also referred to as CDs, are bank-issued money market investments. These investments can be purchased at commercial banks and financial institutions. They can be either short-term or long-term investments, ranging in maturity of anywhere from three months to up to five years. Certificates of deposit are also great for individuals that may not have a lot of money to invest, as they can be purchased in a variety of denominations. Unlike keeping your money in a savings account or a checking account, you will be unable to access the funds while it is tied up in the certificate of deposit.
Similar to a treasury bill, CDs are low-risk and conservative, but oftentimes have higher yields because of the slim chance that a bank were to default or go under. The more risk you take with an investment, the greater likelihood for a better interest rate and financial yield. However, CDs are still considered extremely safe investments, both for short-term and long-term use. Even though most banks offer CDs, the interest rates in which they earn are oftentimes rarely in competition, so it is a smart idea to ensure you shop around at different financial institutions before purchasing a CD. Additionally, banks are FDIC (Federal Deposit Insurance Corporation) insured by the government, so your investment is at least backed with a $100,000 guarantee.
There is one important part about CDs that you should take note of, and that is to pay close attention to the APR (annual percentage rate) and the APY (annual percentage yield). These are two different ways of earning interest on your CD. APR refers to interest that is accumulated in just one year, while APY is interest that is accumulated over several years while including compounding interest.
Here’s how it works: if you have a five year CD that pays based on an APR, you will just receive that percentage based on what you invested. However, if you have a five year CD that pays based of an APY, then you will have the interest accumulated each year ADDED and figured into the following year’s interest. Instead of just earning on what you paid in, you will also earn based off the interest accumulating each year as well. It may not seem like a big deal, but when you are investing thousands of dollars, the compounding interest can add up greatly over a period of time.
CDs have their benefits: they are safe, conservative investments and allow you to know how much you will earn when you purchase them. CDs are at a disadvantage because of the low amount of interest they will earn compared to other money market securities, and your money is not accessible during the maturity time (unless you are willing to take a large penalty for paying it out early).