Certificate of deposit (CD)

Definition

A certificate of deposit (CD) is a financial product offered by banks and credit unions that allows individuals to deposit money for a fixed term in exchange for a higher interest rate compared to regular savings accounts. CDs are considered low-risk investments and typically require the funds to remain untouched until maturity, making them an appealing option for those looking to earn interest without the volatility of stocks or bonds.

5 Must Know Facts For Your Next Test

1. CDs typically offer fixed interest rates that are higher than those of standard savings accounts, incentivizing customers to lock in their funds.
2. The terms of a CD can vary widely, ranging from a few months to several years, allowing customers to choose based on their financial goals.
3. Unlike regular savings accounts, withdrawing funds from a CD before its maturity date usually results in an early withdrawal penalty, which can reduce the overall returns.
4. Interest on CDs can be compounded monthly, quarterly, or annually, impacting the total earnings over the term of the investment.
5. CDs are federally insured up to a certain limit (usually $250,000) if issued by banks or credit unions, adding an extra layer of security for depositors.

Review Questions

• Compare and contrast CDs with traditional savings accounts in terms of interest rates and accessibility of funds.
  • CDs generally offer higher interest rates than traditional savings accounts because they require funds to be deposited for a specified term. In contrast, savings accounts provide greater accessibility since account holders can withdraw their money at any time without penalties. However, the trade-off for higher rates in CDs is that funds are locked in until maturity, which may not suit those who need immediate access to their cash.
• Discuss how the interest rate environment affects the attractiveness of CDs as an investment option.
  • The attractiveness of CDs as an investment option is closely linked to the prevailing interest rate environment. When interest rates are high, CDs can offer appealing returns compared to other low-risk investments. Conversely, when rates are low, investors may find CDs less attractive because the potential returns might not outpace inflation or provide sufficient growth. Therefore, it’s crucial for investors to monitor market conditions and compare CDs with alternative investment vehicles.
• Evaluate the role of certificates of deposit in a diversified investment portfolio and their impact on risk management.
  • Certificates of deposit play an important role in a diversified investment portfolio by providing a stable and predictable source of income through fixed interest payments. They help mitigate risk by offering a safe investment option that is typically less volatile than stocks or mutual funds. Including CDs in a portfolio allows investors to balance higher-risk assets with safer options, ensuring they have access to funds while earning interest without significant exposure to market fluctuations.

Related terms

Interest Rate: The percentage at which interest is calculated on a principal amount, affecting the growth of investments such as CDs.

Maturity Date: The date when a CD's term ends and the principal along with any earned interest is returned to the depositor.

Early Withdrawal Penalty: A fee charged by financial institutions if funds are withdrawn from a CD before its maturity date, designed to discourage early access to the deposited money.