How Does a Certificate of Deposit Work?

Certificate of Deposit

These are important components of a certificate of deposit or a CD, such as a fixed term, fixed interest rate, it’s offered by certain financial institutions, and it is insured.

And I will go over in more detail about each of these four components.

Let’s talk about the CD’s Fixed Term first

The fixed term CD uses more popular terms, such as three months, six months, one year to five years and of course there are CDs that have longer lengths.

The Certificate of Deposits Interest Rate

The CD rate varies with inflation, so basically, it tracks inflation. For example, in the period between 1982-1983, we had double-digit inflation; the interest rate fluctuated between 10 %, 12%to 13% and so on. Meanwhile, when we had good economic times the certificate of deposit rates dropped to 3% 4% 5% 6% and so on. As you can see, the interest rate on a certificate of deposit really doesn’t get you beyond inflation.

However, if you had the foresight and bought 20 yr CDs between 1982 to 1983, you would beat the S&P 500, which has had a historical rate of return of about 11%.

Certificate of Deposits are Offered By

Generally, there are three types of financial institutions that offer certificate of deposits, such as banks, credit unions, and thrift institutions. I have included Merrill Lynch to show you that brokerage houses can offer CDs as well. Brokerage houses are either incorporated as banks, own a bank, or are affiliated with a bank, through whom they provide you with the CD.

Who Insures Certificate of Deposits?

The two insurers of CDs are Federal Deposit Insurance Corporation (FDIC) and the National Credit Union Association (NCUA). While, the Federal Deposit Insurance Corporation Insures CDs that are provided by member banks, the NCUA insurers CDs of credit unions.

Presently, the single accounts are covered for $250,000 and $500,000 for joint accounts. Remember each account is insured for those amounts at a different financial institution. For example, you can have five single CDs worth $250,000 at Bank of America but FDIC will insure only up to $250,000 because the CDs are located at the same bank.

If you have the same five CDs opened at different owner banks, not different branches of the same bank, then your 5 certificate of deposits are insured in entirety.

These are some important guidelines to know regarding certificate of deposits

CD Interest Rate Guidelines

The larger deposits get better or higher interest rates; if I invest $25,000 in a CD, someone who invests 100,000 will receive a better rate.

Also, longer-term certificate deposits get higher rates and it depends on the current yield curve as well.

Usually, smaller financial institutions attract deposits with higher interest rate payouts than compared to larger financial institutions.

Also, the personal CD gets a better rate than a business CD; businesses CDs are for a lesser term. Since, business needs cash on a regular basis, business CDs can’t have long terms.

Also, a CD not insured by the FDIC or the NCUA, affords you a better interest rate because the risk is transferred to you. Under this policy, if the financial institution fails, you cannot recoup your money since it wasn’t insured. I highly recommend that you avoid opening up uninsured certificate of deposits.

Before you invest in a certificate, here are some key facts to keep in mind

CDs require a minimum deposit amount

the highest interest rates are reserved for the higher deposits, on most bases

you no longer get a certificate for your certificate of deposit. It is all done electronically in book entry form. Your bank statement shows the progress of your CD, stating the balance and accrued interest.

CDs are meant to be held for a fixed term, until maturity. Once the term expires and unless you specify at the opening of the CD, the CD will roll over into another fixed term.

the CD is insured through the FDIC and NCUA

there is a penalty for early withdrawal which is usually the interest rate you would have earned. Avoid opening a CD for a long-term, if you believe you might need the funds.

certificates are conservative investment vehicles, for the risk averse investor.

CD interest rates run in parallel with inflation. For example, a CD with 5% interest rate and an inflation rate of 5% means that you really didn’t make any money. This becomes even more painfully clear when you get taxed on your earnings; herein you earn negative earnings. I personally avoid putting my money in CDs , as you can now see it really doesn’t make any sense to do so.

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