Certificate of deposit

Definition

A certificate of deposit (CD) is a financial product offered by banks that allows individuals to deposit money for a fixed term, in exchange for a higher interest rate compared to regular savings accounts. The money deposited in a CD typically cannot be withdrawn until the term ends without incurring penalties, which makes it a low-risk investment option with guaranteed returns.

5 Must Know Facts For Your Next Test

1. CDs generally offer higher interest rates than regular savings accounts because the funds are locked in for a specific period.
2. Terms for CDs can range from as short as a month to several years, allowing investors to choose according to their financial goals.
3. Interest on CDs can be compounded daily, monthly, or at maturity, depending on the bank's policy, which affects the total earnings.
4. Investors often use CDs as part of their overall investment strategy to balance risk and ensure safe returns, especially during volatile market conditions.
5. Many banks offer promotional rates for CDs, which may provide even higher returns for limited-time offers.

Review Questions

• How does the fixed term of a certificate of deposit impact its interest rates compared to regular savings accounts?
  • The fixed term of a certificate of deposit significantly impacts its interest rates because it provides banks with assurance that they can use the deposited funds for a set period. In exchange for this stability, banks typically offer higher interest rates on CDs than on regular savings accounts, which allow more frequent withdrawals. This difference encourages savers who can afford to lock their money away for a while to earn better returns.
• Discuss the implications of early withdrawal penalties associated with certificates of deposit and how they affect investment decisions.
  • Early withdrawal penalties on certificates of deposit can greatly influence an investor's decision-making process. Since withdrawing funds before maturity can result in losing accrued interest or even some principal, individuals need to consider their liquidity needs and potential future expenses before committing to a CD. These penalties ensure that investors think carefully about their financial plans and timeframes when choosing this low-risk investment option.
• Evaluate how the features of certificates of deposit align with risk management strategies in personal finance.
  • Certificates of deposit align well with risk management strategies in personal finance by providing a low-risk investment vehicle with guaranteed returns. Since the principal is protected and offers higher interest rates compared to traditional savings accounts, CDs serve as an ideal choice for conservative investors looking to preserve capital while earning predictable income. This aspect is particularly attractive during times of economic uncertainty when individuals may seek safer options to safeguard their savings.

Related terms

interest rate: The percentage at which interest is charged or paid on an amount of money, typically expressed annually.

maturity date: The date on which a financial agreement or investment, like a CD, reaches the end of its term and the principal amount along with any accrued interest is returned to the investor.

penalty for early withdrawal: A fee imposed on account holders who withdraw funds from a CD before the maturity date, which can reduce the total interest earned.