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How certificates of deposit (CDs) work

Most people do not understand what CDs are. In fact they take any conversation about CDs to be referring to Compact Disks for storing music. If you have been thinking along that line you better read on.

Certificates of deposit are investment options that fall between savings accounts and stocks.

Savings account offer paltry advantages beyond securing your finances. Interests on them are low and they are seriously affected with high inflation rates. On the other hand, stocks are prone to fluctuations depending on the prevailing economy.

CDs offer higher interest rates than savings account. So if you have some cash that you are not intending to spend for some time, you can consider investing in CDs. They will make your cash grow faster.

Another advantage of CDs is that they have maturity dates. Once you invest in them, you can not access your money until the maturity date otherwise you will be penalized in the form of an early withdrawal fee. This is important because it can prevent you from misusing the cash.

¬CDs are great if you are doing well right now and you have some savings lying somewhere that you may want to grow a bit to make sure you can afford your child’s college tuition or just to have a comfortable retirement and you don’t want to turn to the stock market which is very volatile.

CDs and savings account are equally safe because they are both protected with the same insurance under the Federal Deposit Insurance Corporation just like other banks. When you are operating an FDIC-insured bank, a portion of your saving will be secured in case the bank faces liquidation. You will be refunded an amount of up to $100,000. Meaning if your investment exceeds this amount, you can spread it to other forms of investment just to ensure all your funds are safe.

Another similarity between CDs and savings account is that they both earn compound interest. This means the interest your funds earn also earns interest. So, even if the interest percentage is constant, the amount of interest added increases after each interest period.

¬CDs are not the same. Before you settle on one you should shop around to decide which bank to use. For example you may want to know the early withdrawal fee charged, what the policy entails and the annual percentage yield (APY).

The APY refers to the rate of return you earn annually for compounded interest which depends on the number of interest periods. Annual percentage yield should not be confused with annual percentage rate (APR) which is a simple interest rate at the end of a year or the end of the interest period.

As the saying goes, you don’t want to put all your eggs in one basket. You can divide up your funds and invest them in different CDs. This strategy is called CD laddering. Since CDs have different maturity dates, this strategy can allow you to transfer found fund from the one that has matured to another that has not matured so you get higher returns.

Laddering also ensures that you can get some cash from a CD that has short maturity period in case an emergency arises.

A word of caution; do not take a loan while holding a CD. The interest you pay on the loan might exceed the one you get from the CD.

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