A Certificate of Deposit or CD is a special type of time deposit used by many financial institutions, usually a commercial bank. Certificates of deposit generally offer fixed rates of return for periods of 1 month, 3 months, 6 months, 1 year, or more depending on the investor’s preference.
A Certificate of Deposit is generally used by investors who need a short term arrangement to earn a fixed return. CD rates are better than a savings account, but are different in that the money can not be withdrawn until the end of the CD term. Certificate of deposit early withdrawal will cost the investor to pay a large penalty. This means that the investor must be absolutely sure the funds can remain untouched until the certificate of deposit maturity.
Certificates of deposit risks are generally restricted to the early withdrawal because it is unlikely that any of the financial institutions will default on CDs because of their short term nature. CDs that are denominated in $100,000 and above are referred to as negotiable certificates of deposit. This allows the investor to determine the penalty of early withdrawal as well as the rate of return. Other terms can also be calculated into the negotiable CD.
Bob has $1,000 in a savings account, but he would like to earn a greater return than the 0.5%. Bob goes to his bank and decides that he would like to invest his funds into a certificate of deposit so that he might earn a more meaningful return from the bank. The bank offers CD terms of 1.35% for a 3 month period. Bob decides to go forward with the agreement and at the end of the 3 month term he has earned interest of $3.38. This number is opposed to the $1.25 that would have been earned had Bob stayed with the savings account.