A CD is an investment option offered through banks or brokerages. It is a way to save money and earn a higher interest rate than with a simple savings account. A CD is also a way to gain money through investing, but without the substantial risks you may find with other investments.
Often, the hardest part of deciding on and purchasing investment options is understanding the process and the terms. It's no different with CDs. Here, we present a glossary of the CD vocabulary to better explain the product and its advantages and disadvantages.
Liquidity: In a savings or checking account, your funds are liquid. This means that you can withdraw as needed without penalties. In a CD, you are placing a certain amount of money in a locked fund. It is not liquid, meaning you cannot withdraw funds without penalty.
Term: CDs are defined by the amount of time funds are locked, called terms. CDs are available in many different terms, usually ranging from three months to five years. Over the term your funds accrue interest and are not available for withdrawal without penalties.
Interest: Important to note with CDs are the higher interest that can be earned than in savings accounts. This is the attraction of locking up funds for a set term – interest will accrue, and can either be paid out in regular intervals or added to the principal.
Mature: A CD is mature when the term is finished. At this point, consumers have the option to "roll-over" their CDs.
Rollover: When a CD is mature, you can opt to withdraw the funds, or you can roll the money over into a new CD account. This is attractive to some consumers in order to continue growing income through interest.
Withdrawal Penalties: For different CDs, the conditions for withdrawing funds before maturity vary widely. You will be required to pay amounts ranging from few months interst to all the interest you earned for your CD.
For example, a consumer who bought a 12-month CD is expected to leave the funds alone for a year. But this consumer decides to withdraw funds within two months of opening the CD. The penalty for doing this is three months worth of interest. See the problem? Not only is this consumer required to repay all interest he has received during the first two months, but also an additional month of interest. He has to dig into the principal to pay the penalty. He has lost money in the entire CD process.
Banks, credit unions, brokerages, and online institutions can issue CDs. Numerous types of CDs exist, each with their own set of advantages and risks.
CDs are considered one of the safest forms of investment. Not only does your money accrue higher interest than a savings account, your funds are protected by federal insurance, usually up to $100,000. In addition, if consumers are smart about their CDs, compounding interest can create remarkable return on investment and growing income. How?
As mentioned previously, CD owners have the option to receive interest from their CD account paid out in regular installments. This may be a nice bonus income, but compounding interest is a much smarter option. Instead of receiving interest payments, consumers can add interest income to their principal. More principal equals more interest. More interest can then add to the principal again. This is the compounding process, and accounts for great investment results.