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When the stock market ups and downs become too much for some investors, they turn to more traditional and safe ways to invest their money, including certificates of deposit. With a CD, you make a commitment to a bank to leave a specified sum of money on deposit for a specific time period. The bank, in exchange for this promise, pays a higher interest rate on this investment than it would on a regular deposit account. Depending on what the individual is looking for, a CD can be a good investment opportunity.
You must consider your investment goals when determining if a CD investment is right for you. If your goal is a safe place to park some cash for a fixed time period, a CD is a good place to accomplish this goal. A CD is also a good part of a diversified portfolio that you set up to minimize your overall risk of loss. If you want to grow money long-term to outpace inflation, you should look at other investment options.
A CD's safety comes from the fact that CDs purchased through an FDIC-insured financial institution are protected against loss resulting from failure of that financial institution. As of the time of this publication, deposit accounts are protected up to $250,000 total with any one institution. If you wish to invest more than this in CDs and maintain FDIC protection, you can open additional CDs at other FDIC-insured banks.
CDs offer a predictable way to invest. The return on a CD is usually fixed, although some newer CDs offer variable rates and other differences in an attempt to make them more competitive with other investments. The interest is either paid periodically, or at the end of the CD's deposit term. The predictability can make a CD a good way to formulate a solid financial plan.
A CD's higher interest rate when compared to a regular deposit account comes at a price. CDs carry a penalty if you withdraw money before the maturity date. The penalty could be a portion of the principal deposited, or the bank could levy a penalty equivalent to the interest on the account for a certain time period. For example, the bank may impose a penalty of three months' worth of interest if you withdraw early.
While CDs are protected by FDIC insurance against loss of value, they carry another risk of loss of the money's purchasing power over time due to inflation. CDs generally carry very low interest rates, and these rates may not keep pace with inflation. If a CD pays an annual rate of 2 percent, but inflation is shrinking the purchasing power of the money by 3 percent each year, the account is experiencing a loss in purchasing power of 1 percent each year.