A certificate of deposit is a time deposit in which you commit to keeping a specific amount of money at a financial institution for a few months to a year or more. In return, the bank or credit union pays you interest above what you would get from a savings or money market account, from which you could withdraw funds anytime. CDs are safe investments but can produce relatively low returns.
Safe and Sure
CDs issued by a federally insured bank or credit union are safe. The bank or credit union will pay your principal and final accrued interest when your CD matures. If your bank fails, the Federal Deposit Insurance Corporation will pay you the principal and interest accrued as of the day the bank closed. If your credit union fails, you will be paid by the National Credit Union Administration. Bank or credit union CDs are insured up to $250,000 per financial institution, as of 2012. CDs also offer a fixed interest rate, so you know how much interest you will receive when they mature, regardless of interest-market fluctuations.
Easy to Get
CDs are easy to obtain -- you can simply walk into your bank or credit union and buy them over the counter. Minimum investments at many institutions are $500 to $1,000, but some banks have no minimum. If you have money in an existing savings account, you can transfer it to a CD. You can also buy CDs through a brokerage that acts as a middleman between you and issuing banks. Brokered CDs may offer a higher interest rate because of volume purchases by the brokerage.
Funds Tied Up
A disadvantage of CDs is that you must tie up your money for long periods. In general, the longer the maturity term, the higher the interest rate. If you are forced to cash in your CD before maturity, you usually incur a substantial loss of interest as an early withdrawal penalty. Typically, you lose three months' interest on a CD maturing in one year or less and six months interest on a CD with a maturity of more than one year.
Price of Safety
The price of CD safety is an interest rate that's typically lower than what you can get with somewhat riskier investments. These include corporate bonds and preferred stock from companies with credit ratings of BBB and above, bond mutual funds, and fixed annuities from top-rated life insurance companies. As of 2012, many banks were paying up to 1 percent on one-year CDs and up to 1.75 percent on five-year CDs. The low- to moderate-risk alternatives to a CD paid 0.5 percent to 2 percent more than this. The fixed interest rate on CDs can work against you. If market interest rates rise substantially, you will be locked into the lower rate.
Allowing for Taxes
In figuring your return on your CD investment, you have to allow for income taxes. CD interest is subject to federal, state and local income taxes in the year it is earned, regardless of whether the interest is paid to you or left in the CD. If the CD is held in an individual retirement account, the interest accrues tax-free. With tax-deferred IRAs, taxes on the interest are deferred until the CD is cashed in at retirement. With Roth IRAs, the CD interest will be tax-free at retirement.