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Understanding a Certificate of Deposit (CD)



Understanding a Certificate of Deposit (CD)

Most people are familiar with checking accounts and savings accounts in banks. However, these instruments are not really designed for long-term savings. In fact, they are intended for frequent transactions and short-term storage of money before it is used. Instead, banks provide two other tools for better benefits: the money market account and the certificate of deposit (CD).

CDs Begin to Make Sense for Big Savers

While the money market account provides more value, it’s really geared for accounts with a high volume of inflow and outflow that maintains a sizable balance throughout. However, certificates of deposit (CD) provide a safe way to save large amounts of money for a long-term placement as well as with a better rate of interest paid back to the account holder.

In all savings vehicles, the bank is essentially using the saver’s money to turn around and provide new loans to other customers. This is how a bank generates income. That said, accounts where the money moves quickly don’t provide a reliable source of funds for lending out. So, banks pay very little interest for short-term holding balances, or none at all. Instead, the cost of the account is recaptured in account fees.

A CD Protects Money and Pays a Profit

The certificate of deposit, however, works as a win-win financial investment tool. For those who want the ultimate safety of protecting their money, banks are the best place to put such funds. Being insured by the government, the risk of loss is practically nil. However, as mentioned above, the earning power is also nothing. So, there’s not much incentive to use a basic account. Since banks want money to work with for lending but they also want to be able to rely on its availability long-term, the CD provides banks with the ability to hold onto the funds, and the saver gets rewarded for the commitment with a higher interest rate.

Different Time Windows Pay Different Rates

CDs come in different forms as well. Those that involve a commitment of a large amount of funds get paid more interest than smaller CDs. Also, CDs that stay committed much longer, measured in years, receive higher interest rates than those for only a short period, like a single year only. The account holder is always in charge, choosing the CD that works best, but once a commitment is made, the money is then locked up for the duration.

CD Holders Can Still Get to Their Money if Needed

Despite the above, CDs can be cut short prematurely. Depending on the terms, most CDs allow the account holder to withdraw their funds early. When this happens, however, then the account holder agrees to give some portion of the interest earned. For short-term CDs, this is not very painful, but for long-term CDs the loss can be substantial. That said, it is possible to cancel a CD in absolute emergencies when the need arises.

There is Still Taxation

CDs are not immune to taxes. Any income earned is taxable. The difference comes in the type of CD. For instance, regular CDs generate interest which is treated as a normal gain and taxed in the year it is earned, i.e. whenever the CD pays out. On the other hand, a retirement account CD doesn’t owe any taxes right away. Instead, the gain compounds and can grow further. It is only when the funds are liquidated and withdrawn from the retirement account itself that are taxes actually paid on the CD gains. 

Everyone Should have a CD or Two

Certificates of deposit (CD) tools just make sense for protecting large amounts of money and getting something back for it as well. They still enjoy bank protection from the government, and the interest allows the CD value to grow over time. While they won’t deliver gangbuster profits like a public stock, they also don’t have the risk of losing everything. As a result, CDs should be a go-to finance tool for anyone needing to save money they don’t need to access right away.