How Does a Certificate of Deposit Work

How does a certificate of deposit work? Commonly referred to as "CDs," certificates of deposit allow consumers to store their money in an account for a certain amount of time in return for a specific interest rate. Now, with online certificates of deposit, they are even more convenient to buy. Before buying a certificate of deposit, however, you should understand their benefits and risks.

Short-Term Savings
Certificates of deposit are short-term savings accounts. This means that all funds invested in a CD can be held there only for a short period of time. When you buy the CD, the interest rate is fixed, and it won't go up or down while you keep your money in the account. Once the CD expires, you get the money back, plus the interest. With CDs, the bank will offer you lower interest rates that returns offered by other investments, such as stocks, but CD rates are fixed, which helps protect you in case the economy takes a sudden dip.

FDIC-Insured Certificates Of Deposit
Before investing in a CD, it is crucial to make sure it is insured by the Federal Deposit Insurance Corporation. Not all of them are, so it is your responsibility to read the fine print. This insurance will protect you from any misuse of funds by the banks or sudden cancellation of the CD. Don't be tempted to invest in CDs that aren't FDIC insured, even if they offer higher interest rates. If the CD is not insured by the FDIC, the money is not entirely secure, and you could lose your principal.

Withdrawal Penalties
Banks are able to set the interest rate because they don't expect you to withdraw the money until the CD expires. To use a CD, you must agree to this condition and be willing to tie up your money for a while. Keeping the funds in the CD allows the bank to accrue interest, and you will have to pay a penalty if you choose to withdraw funds.

When CDs Are A Good Idea
While relatively impractical for investments of tiny amounts, they are a good option for conservative investors, and they may build up considerable amounts of money over time. That said, all investments involve risk, and CD's are no exception. CDs are not a good idea if you don't think you can risk tying up your money for a few months. As with any investment option, you must have knowledge of your options and be aware of the risks.

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