A certificate of deposit, also referred to as a CD, is a relatively low-risk investment vehicle that is offered by most banks, credit unions and other savings institutions, reports the Federal Deposit Insurance Corporation, (FDIC), an independent federal agency that identifies and monitors deposit insurance funds. Brokerage firms also sell CDs that carry a variety of risks and benefits. Below is an overview of the advantages and disadvantages of placing your money into a CD.
Safety
Certificates of deposit are insured by the FDIC for up to $250,000, protecting investors from bank failures and other unforeseeable circumstances. Fixed-rate CDs are not tied to the stock market, but offer guaranteed returns. Market-linked CDs are riskier since the payouts are tied to market influences, but still maintain a minimum guaranteed return.
Payments
Payments from CDs typically are given at the end of the original commitment and pay back the original investment plus interest. Payments can be lost however if the CD has to be cashed in sooner that expected. CDs typically carry penalties for early withdrawal. Traditional CDs pay a set interest agreed upon at the time of purchase. Variable CDs carry interest rates that increase or decrease over time and do not provide assurance of a set payment at maturity.
Interest
While the interest is usually predictable, the downside of CDs is that they often pay lower interest rates than other investment vehicles, report investment advisors at Morningstar. At the same time, a certificate of deposit may provide higher rates of interest than more unpredictable bonds, another relatively safe investment that risk-averse investors enjoy. Returns on market-linked CDs are taxed at a higher rate than capital gains, report investment advisors at Buy Upside. The upside of a market-linked CD is that in addition to the guaranteed interest, the investor could receive a higher return if the market performs well based on a measured index.
Time
A CD typically is purchased for a fixed fee for a fixed period of time, reports the FDIC. CD commitments range from six months to one year or five years or more. The longer the CD has to mature, the higher the interest paid to the investor. The bank typically agrees to pay a set amount of interest on a regular basis over the agreed-upon period of time, which is a good choice for investors who can safely predict their cash-flow needs, report Morningstar investment advisors. The FDIC reports that newer CD products offer variably rates of interest and other features that could allow the bank to terminate the investment earlier than the maturity date.
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