A certificate of deposit is a special type of deposit account that pays regular interest and guarantees the original investment back after maturity. CDs typically offer higher interest rates than regular savings or checking accounts, but you would incur penalties if you cash in or redeem your CD before it matures. CDs are part of the fixed-income component of diversified investment portfolios. You can buy CDs from banks and other financial institutions.
The strengths of a CD include safety of principal and periodic interest income. They are ideal investments for retirees who depend on interest income for their living expenses and cannot afford to lose any part of their savings. You can choose from a wide selection of CDs with different terms, interest rates and maturities. CDs lock in interest rates until maturity — falling interest rates will have no effect on what you receive from your CDs. You do not have to worry about capital losses either, because you will get the principal back on maturity. In addition, the Federal Deposit Insurance Corp. insures CDs up to certain amounts.
The weaknesses of a CD include low liquidity and potential loss of purchasing power due to inflation. You cannot redeem part or all of a CD account without losing some of the accrued interest and possibly even the principal. You should check your CD account agreement to determine the penalties if you need to cash out early. Money market mutual funds and U.S. Treasury bonds might be better investments if you need access to emergency funds. Strong economic growth often leads to inflation, which can put pressure on short- and long-term interest rates. However, CD rates take a while to catch up to rising rates, so you could be earning less interest income than other fixed-income investments. There is no capital gains possibility on regular CDs, although some institutions offer CDs that offer a way to participate in stock market gains.
Index-linked CDs, also known as market-linked or equity-linked CDs, provide you regular interest payments along with the opportunity to participate in the gains of a market index, such as the S&P 500 index. The FDIC still guarantees the principal, but you could lose a portion of the principal if you redeem one of these CDs before maturity. The issuer may impose limits on the amount you can earn. It may also have the right to buy back its CDs before maturity, which could mean a lower effective return on investment.
The FDIC recommends that you carefully read the disclosure statements before investing in a CD. You should also remember that FDIC protection only applies to CDs issued by FDIC-insured banks. Other investment options with similar risk-reward profiles include U.S. Treasury bonds, money market mutual funds and government bond mutual funds.
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.