CDs

Definition

CDs, or Certificates of Deposit, are a type of savings account offered by banks and credit unions that provide a fixed interest rate in exchange for the customer agreeing to keep their money deposited for a specific period of time. CDs are commonly used as a low-risk investment option to earn a higher return than a traditional savings account.

5 Must Know Facts For Your Next Test

1. CDs typically offer a higher interest rate than a regular savings account, but the customer must agree to leave the money deposited for a fixed term, such as 3 months, 6 months, or 1 year.
2. The interest rate on a CD is fixed, meaning it will not change during the term of the CD, providing a guaranteed return on the investment.
3. CDs are considered a low-risk investment option because the principal is insured by the FDIC (Federal Deposit Insurance Corporation) up to $250,000 per depositor, per insured bank.
4. Early withdrawal from a CD before the maturity date may result in a penalty fee, which can reduce the overall return on the investment.
5. The simple interest earned on a CD is calculated by multiplying the principal amount, the interest rate, and the time period (in years) that the money is deposited.

Review Questions

• Explain how the simple interest formula can be used to calculate the interest earned on a CD.
  • The simple interest formula, $I = Prt$, where $I$ is the interest earned, $P$ is the principal amount, $r$ is the annual interest rate, and $t$ is the time period in years, can be used to calculate the interest earned on a CD. For example, if you deposit $1,000 in a CD with a 2% annual interest rate for 1 year, the simple interest earned would be $I = $1,000 × 0.02 × 1 = $20. This interest, along with the original $1,000 principal, would be available for withdrawal at the CD's maturity date.
• Describe the key factors that influence the interest rate and term length of a CD.
  • The interest rate and term length of a CD are influenced by several factors, including the current market interest rates, the bank's or credit union's policies, the amount of the deposit, and the length of the term. Generally, longer-term CDs (e.g., 1 year or more) offer higher interest rates than shorter-term CDs (e.g., 3 months or 6 months). Additionally, larger deposit amounts may qualify for higher interest rates. The bank or credit union also considers its own funding needs and profitability when setting CD rates and terms.
• Analyze the potential advantages and disadvantages of investing in a CD compared to a traditional savings account.
  • The primary advantage of investing in a CD is the potential to earn a higher interest rate than a traditional savings account, providing a guaranteed return on the investment. CDs also offer the security of FDIC insurance, protecting the principal up to $250,000 per depositor. However, the main disadvantage of a CD is the requirement to keep the money deposited for the full term, typically ranging from 3 months to 5 years. Early withdrawal may result in penalty fees, which can reduce the overall return. In contrast, a savings account offers more liquidity, allowing the customer to access their funds at any time without penalties. The tradeoff is that savings accounts typically offer lower interest rates than CDs.

Related terms

Simple Interest:

Simple interest is the interest earned on the principal amount of an investment or loan, calculated as a fixed percentage of the principal over time.

Maturity Date: The maturity date is the date when a CD or other fixed-term investment reaches the end of its term, and the principal and earned interest are available for withdrawal.

Principal:

The principal is the initial amount of money deposited or invested, which earns interest over time.