What is it?
A type of investment offered by banks (and savings and loans, and credit unions, etc.) characterized by the following…characteristics:
- It is an instrument of debt, as opposed to equity. (Basically, equity is ownership of the firm and debt is debt.)
- It is a short- to medium-term investment. CDs are offered for terms from 3 months to 6 years, generally. There is always a penalty for withdrawing the money early.
- It earns interest. The interest is fixed (printed on the certificate given to the debtholder) and paid to the debtholder periodically.
- It is FDIC-insured.
CDs are
low-risk, low-return investments. However, they earn a higher rate of return than most other investments in their class because the money is committed for the term of the CD. If someone
loaned you $100 and said they might demand repayment at any time, you’ll be a little more cautious than if someone loaned you $100 and promised not to demand repayment for at least 12 months. Banks are willing to pay for that
security, so CDs earn more interest. It then follows that the lengthier the term on the CD, the higher the interest rate earned. It would follow again that the more money invested, the higher the rate of return. Insurance by the
FDIC basically kills any investment risk that might be involved, so a CD is about as safe as a
savings account.
Note: I live in the US. Internationally, of course, things work and are named a little differently. For example, In Europe, a bond which is issued in any foreign currency is a Eurobond. A Eurocurrency deposit is a certificate of deposit issued in a foreign country. CDs issued in US dollars in London are called Eurodollar deposits, and CDs issued in Japanese yen in Germany are called Euroyen deposits. The laws in different countries might treat these things differently, but the basic debt instrument, the CD that is, is the same the world over. Fixed interest, fixed term, low risk.
What are CDs good for?
If you happen to have a large amount of cash on hand, and you don’t want it sitting around collecting dust in a savings account (most people are lucky to earn 1.5% annually), you could consider a CD for as little as 3 months. At least then you’d be defraying the costs of inflation on your money, which, for the meantime, is safe from the whims of the stock market.
CDs are not good for long-term investing or retirement saving (except as part of a diversified portfolio). They do not earn enough interest to be worth it to anybody with at least 20 years left to save towards their goal. Lately, in the US, the shorter term CDs have a rate of return that is lower than our inflation rate...thanks mainly to a dozen interest rate cuts by the Federal Reserve since 2001.
It's also inconvenient to have your money tied up for a set amount of time, as liquidity is highly valued to any investor. The most common tactic used to combat this is the creation of a laddered portfolio. The investor walks into the bank every year and invests one fifth of his money in a five-year CD. Then, every year, one fifth of his money is freed up to use or reinvest. This tactic also rides the market fairly well, since our investor doesn't have to invest all of his money at a time like this, and he also takes advantage of the higher rates offered for longer CDs.