"What are Certificates of Deposit"
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Basically, certificates of deposit or CDs for short or savings certificates are a form of savings account.
However, you give up the liquidity of an ordinary passbook savings account in exchange for a higher rate of interest.
Also, it takes more money to open a bank certificate of deposit than an ordinary passbook savings account.
Traditionally, certificates of deposit accounts are offered by banks, savings and loans and credit unions -- local financial institutions. You give them your money to loan out for interest. That's how banks make their money, by loaning money to businesses and people and making a profit on the interest.
In exchange, they agree to pay you interest every month or quarter or six months or whatever the exact terms are.
So far, it's much like savings account.
With Most Savings Certificates, the Interest Rate Paid is Fixed
Also, the CD lasts for a certain period of time. It could have a maturity date of six months or 15 years in the future.
You cannot withdraw the money out of the certificate of deposit without incurring a withdrawal fee -- so they are time deposits.
In effect, you lose access to your money much more than with a savings account, but in exchange for this loss, you're rewarded with a higher rate of interest paid to you on this money.
Savings certificates are insured by the Federal Deposit Insurance Corporation or FDIC up to $100,000.
Some Certificates of Deposit CDs Do Not Pay a Fixed Rate of Interest
Typically, they may a higher rate the longer you hold the CD. They're called variable certificates of deposit.
Some certificates of deposit are callable. That is, if interest rates go down a lot in the future, the bank may decide that it no longer can afford to pay you the high rate of interest it originally agreed to. Therefore, it calls the CD -- it cancels the certificate.
Of course, you get the principal amount back, plus any interest due -- but you then are faced with reinvesting it at a lower rate.
Also, savings certificates can now be offered by brokerage firms and individuals who are called deposit brokers. These brokers typically gain customers by offering higher rates. Then they go to financial institutions and get the higher rates through purchasing CDs in volume.
Ownership of the CDs is Aggregated
This is sort of like a mutual fund of certificates of deposit.
The $500 you invested may have bought 1/2 of a $1000 certificate of deposit and you share ownership of it with someone on the other side of the country.
The higher the principal you put into the bank's certificate of deposit -- that is, the higher the face value, the more interest it will pay. You get the highest rate for Jumbo CDs that have a principal value of $95,000 or $100,000.
At the end of the maturity period, the bank will notify you that the certificate of deposit period is almost over and tell you what current savings certificate interest rates are now. If you don't tell them differently, they'll rollover the principal into a new CD which will pay a different rate of interest.
Many people have their savings certificates automatically rollover at the end of the maturity periods.
You can usually reinvest your interest payments back into the certificate of deposit, so your principal will compound.
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