Certificates of Deposit

What is a Certificate of Deposit (CD)?

A certificate of deposit (CD) is like a loan from an investor to a bank or similar thrift institution. It is issued by these banking institutions and pays interest. CDs are among the most widely used money market instrument by investors overall. They are issued for varying maturities, and earn interest based on this maturity. The most common CDs include 31-day and 91-day maturities. For these CDs, the yields are tied to the 13-week Treasury bill rate. Six-month and 30-month CDs will generally yield higher rates, and they are also tied through some formula to Treasury bills. They are useful for the average investor because they are available in sums as little as $100. Bank CDs can be tailored to meet your individual requirements, as well. They are one of the most flexible investing tools. CDs are like bank deposits and are covered by federal insurance up to $100,000 per account.

"Jumbo" CDs

Jumbo CDs are often used by institutional investors and other heavy-duty investors. They have a minimum of $100,000 and therefore subject the investor to added risk not covered by the federal insurance. Jumbo CDs allow investors to obtain capital gains due to fluctuations in interest rates, but this tends to be a very sophisticated, high-level process for the individual investor.

"Designer" CDs

There have been many changes in the banking system in the last few years that have made possible a variety of options for CD investors. Interest rates vary with the length of the CD that you purchase. Longer maturities and larger CDs generally pay higher rates. Now it is possible to find practically any combination of maturity/CD size to meet investors' needs in what are called "designer" CDs. These types of CDs are offered by many savings institutions and allow investors to invest whatever sum they want in the form of a CD. If an investor has an odd sum of money available for investment, he/she can obtain a CD built specifically around their requirements.

Calculating Interest

Interest can be calculated in a variety of ways, as is the case with any investment. The way in which interest is ascertained is very important. Interest can be simple or compounded. A 7 percent CD rate that is compounded daily will have an effective yield of 7.25% over the course of a year. If it were compounded annually, then the effective yield would be only 7%. The interest rates on CDs vary practically day-to-day. These interest rates are determined, in large part, to competitive forces in the marketplace on Wall Street. These forces are collectively referred to as "market makers." This type of information is important to know when you are investing in a CD.

Obtaining a CD

CDs are most commonly obtained through a direct purchase from a savings institution. Some brokerage firms, however, pool together CDs from institutions from around the nation and make this available to investors. These pools are generally geared towards the jumbo CDs and, therefore, towards the institutional and heavy-duty investors. Again, these types of "pooled" CDs will not be wholly insured by the federal government.

The Investment Potential of CD

Most people invest in CDs for income. The maturities of CDs vary anywhere from seven days to seven years. Most of these CDs offer a fixed interest rate for the specified maturity. In recent years, however, variable CDs have been introduced. These CDs offer variable interest rates based on a preset formula. Variable CDs will offer interest rates that are slightly lower than the current rates, but in exchange, the investor is given added flexibility. The lower rates have the potential to rise in the future, and you would then be able to reap its benefits. On the downside, CDs offer very little protection against inflation. In addition, they do not offer individual investors any capital gains potential.

Strengths of Investing in CDs

There are both many strengths and weaknesses to investing in a certificate of deposit. CDs under $100,000 are insured by the federal government. For the individual investor, this is a very major cushion. In addition, the wide variety of maturities does not lock you in to any one situation. You have many options when investing in CDs--they are one of the most flexible investing tools. Furthermore, no fees or commissions are assessed when investing in CDs. They can also be purchased for a sum as little as $100. But best of all, CDs offer a secure fixed compounding of income over the selected maturity that you have purchased!

Weaknesses of Investing in CDs

The liquidity of CDs is very limited. You cannot withdraw your money from CDs prematurely without incurring some sort of penalty. In some cases, banks will not allow you to withdraw your money at all. If the economy of the nation becomes inflationary, investments in CDs will suffer a loss in purchasing power. Also, CDs will not yield you the highest possible yield as opposed to other investments, but the risk is also less in CDs. This is another example of the concept of Risk vs. Reward.
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