Friday, August 1, 2008

Learn the lingo: CD (Certificate of Deposit)

I mentioned the term "CD" in my emergency fund post recently, but it dawned on me the other day that the word may not mean anything to all who are here to learn about the financial ropes of your lives. If any terms are at all archaic-sounding or confusing, leave me a note and let me know; you'll never be able to be the savvy capitalist you aspire to be if you can't navigate the ropes, after all! Which brings me to CDs, or certificates of deposit.

Much like a savings account, a CD is simply a place where you can keep your cash -- except with more perks! By putting your money in a CD, you promise the bank to leave your cash untouched for a certain amount of time (usually three months at the very minimum). The bank then rewards you for your promise by paying you a higher interest rate! It's basically how a loan works, but in reverse, i.e., you loan the bank your money, and they pay you for the right to hold your money for a certain chunk of time. Its that certain je ne sais quoi that's missing from just leaving your savings in a savings account (which generally has a very low interest), or in a shoebox somewhere in your close (which, sadly, yields no interest).

The interest rate the bank pays you is based on how long you agree to keep your money under lock and key with them. The longer you sign the contract for, the more money you get from them in the long run, although it depends on where you bank to determine how much more. According to, six-month funds usually pay back 4.6% or more, but the best five-year CDs yield as little as 0.34% more than the six-monthers, and penalties for pulling out money early can be about three to six months of the interest you accrued from them. Translation: It doesn't always make sense to go with a longer CD, especially if you think there's a good chance you'd pull your money out prematurely.

And, for all of you worried that the current recession will harken back to the any semblance of the Great Depression, CDs are, of course, FDIC insured (up to $100,000).

If the thought of paying a penalty fee for money you may need in an emergency doesn't quite float your financial boat, consider laddering your CDs, which is just a fancy way of saying invest in a surfeit of CDs all at once, but with staggered maturity dates. This way, for example, you could invest in four different CDs (let's say a six-month, one year, two year and three year) and have them expire at different times, freeing up your money (plus interest) if you should so need it. If not, you can put it right back into more staggered CDs, dodging any stuffy penalties!

So coming back to the real crux of the whole situation, why are CDs a potentially smart investment? Simple. Because there are penalties for withdrawing money before your time is up, you have much more motivation to leave your savings untouched. Add to that a pre-determined interest rate you know the bank will pay you (versus up-in-the-air returns associated with riskier investments such as the stock market), and you can see why CDs may be the smartest place to keep your savings. The con, of course, is that you by siging into a CD, you cannot withdraw your money at any time (like a savings account) without facing a penalty.

Sometimes, though, that's the perfect amount of risk for an up-and-coming gal on a budget.

1 comment:

Cali Bar Girl said...

I love CDs! This:

is a great site to see which banks have the best rates for the period of time you want to invest.

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