Certificates of Deposit

Definition

Certificates of deposit (CDs) are a type of savings account offered by banks and credit unions that pay a fixed interest rate in exchange for the customer agreeing to keep their money deposited for a specific period of time. CDs are considered a low-risk investment option and are commonly used by individuals to save and earn interest on their money.

5 Must Know Facts For Your Next Test

1. CDs typically offer a higher interest rate than traditional savings accounts, but require the customer to keep their money deposited for a set period of time, usually ranging from a few months to several years.
2. The longer the term of the CD, the higher the interest rate the bank will offer, as the bank is able to invest the deposited funds for a longer period.
3. CDs are considered a low-risk investment because the interest rate and maturity date are fixed, providing a guaranteed return as long as the customer holds the CD until maturity.
4. Customers can choose from a variety of CD terms, with the most common being 3-month, 6-month, 1-year, 2-year, and 5-year CDs.
5. CDs are often used by individuals who have a specific savings goal or need for their money at a future date, as the fixed maturity date and interest rate can help them plan their finances accordingly.

Review Questions

• Explain how certificates of deposit (CDs) differ from traditional savings accounts in terms of interest rates and withdrawal policies.
  • Certificates of deposit (CDs) typically offer higher interest rates than traditional savings accounts, but require the customer to keep their money deposited for a set period of time, known as the maturity date. This fixed term allows the bank to invest the deposited funds for a longer period, enabling them to offer a higher interest rate. In contrast, savings accounts generally have more flexible withdrawal policies, allowing customers to access their funds at any time, but with lower interest rates. However, CDs also come with early withdrawal penalties if the customer needs to access their money before the maturity date, which is not the case with traditional savings accounts.
• Describe the role of FDIC insurance in providing protection for funds held in certificates of deposit.
  • The Federal Deposit Insurance Corporation (FDIC) insures certificates of deposit (CDs) up to $250,000 per depositor, per bank. This means that if a bank were to fail, the FDIC would step in and ensure that the customer's CD funds are protected and returned to them, up to the $250,000 limit. This FDIC insurance is a key feature of CDs that makes them a relatively low-risk investment option, as it provides a safeguard for the deposited funds. The FDIC insurance helps to instill confidence in customers who are considering investing in CDs, as they can be assured that their money is protected in the event of a bank failure.
• Evaluate the factors that individuals should consider when deciding between investing in a certificate of deposit (CD) or a traditional savings account.
  • When deciding between a certificate of deposit (CD) and a traditional savings account, individuals should carefully consider their financial goals, time horizon, and risk tolerance. CDs typically offer higher interest rates than savings accounts, making them a more attractive option for individuals who have a specific savings goal and can commit to keeping their money deposited for the full term. However, CDs also come with early withdrawal penalties, which can be a drawback for those who may need to access their funds unexpectedly. Conversely, savings accounts provide more flexibility and liquidity, allowing customers to withdraw their money at any time, but with lower interest rates. Ultimately, the choice between a CD and a savings account will depend on the individual's financial needs, investment timeline, and risk preferences, as well as their overall financial planning strategy.

Related terms

Maturity Date: The date when a CD reaches the end of its term and the deposited funds, plus any accrued interest, become available for withdrawal.

Early Withdrawal Penalty: A fee charged by the bank if the CD holder withdraws their funds before the maturity date, which is intended to discourage early withdrawals.

FDIC Insurance: The Federal Deposit Insurance Corporation (FDIC) insures CDs up to $250,000 per depositor, per bank, providing protection for the funds in the event of a bank failure.