What Are Certificates of Deposit and How Do They Work?

Certificates of Deposit (CD) are monetary instruments that function like a savings account. Interest is paid on the initial investment at a rate dependent on the length of time the CD is held. One decides on the length of time when the CD is purchased. Common CD lengths range from as short as six months up to ten years or longer. CD interest rates also vary over time and change weekly. Purchasers must do research and compare rates to find the best CD.

CDs are sold via banks and some other financial institutions. What the institutions do with the money is up to them and most generally invest it in stocks or bonds or use it in the form of loans. A portion of their profit is returned to the purchaser in the form of interest and the rest the bank keeps as their profit. CDs are very safe investments making them a good way to balance an investment portfolio.

Occasionally, to attract many investors, banks will offer a higher interest rate on shorter term bonds when they are in need of a quick infusion of capital. Purchasing these CDs offers not only the advantage of higher interest payments, but the ability to quickly reinvest your capital in other opportunities. Investors should always be on the alert for such deals.

When the CD reaches maturity, meaning that you can redeem it for the full interest amount, you have two options. You can either cash the CDs or do what's called a roll over and reinvest the CD for an additional period of time. Upon maturity, the CD will automatically roll over if you do not cash it. When you do a roll over, you can select a new length of time if you choose. Depending on the CD, roll overs will also allow you to defer any tax payments. This is especially beneficial to people nearing retirement age.

CDs are also a very good form of collateral. Banks and other lending facilities will gladly accept a CD as a form of collateral on a personal loan. In rough economic times, when loans are hard to acquire, this may be a perfect answer to your financial needs. Your Certificate of deposit will continue to collect interest while being held as a form of collateral. Most banks will offer very low interest rates on personal loans when a CD is used this way. Private lenders will also accept this type of collateral on a personal loan, but may not give as low of interest rates on the loan as the original bank that issued the CD.

CDs can also be used as a form of collateral against a loan just like a car or a house. This is an excellent way to secure a loan as the CD will continue to accrue interest as you pay off the loan. Interest rates on loans secured with CDs are generally very low since there is little risk involved.

In summary, CDs are a low risk, useful way to save and invest money. They offer diversity to any investment portfolio and can be used to secure loans while they are still earning you interest. Do the research, find the best rate, and purchase some CDs soon.

Todd Fletcher has been involved in financial analysis since 2007. Visit Ratelines.com for more of his advice on money markets.

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