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What is a Certificate of Deposit (CD) and Why Should I Invest in One?

Updated on May 31, 2011
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Simple Investing to Preserve Your Capital

When you purchase a Certificate of Deposit, or CD, from your bank, you are locking away your funds for the term of the CD, and allowing the bank to invest that money for you. In return, the bank will offer either a variable or set interest rate that will pay you back over time a guaranteed rate of return. Basically, think of a CD like loaning your money to the bank.

The term of your CD could be three months or seven years, or any other number of months or years. What matters more than the number of years is the frequency of the payout. Pay attention to whether the CD generates interest quarterly, monthly, weekly, or annually. Most CDs will generate interest monthly.

Who Invest in a Certificate of Deposit?

The two biggest reasons to Invest in a Certificate of Deposit are preservation of capital, and diversifying your portfolio with something stable and reliable.

For instance, if you plan on purchasing a car later in the year, placing your down payment into a 6-month certificate of deposit will earn interest on the down payment, while securing the money in a form that is FDIC-insured, and difficult to access before the end of the CD's term. Also useful, for part-time freelancers, unexpected income, like a book advance or a large adword payout, can be converted into a CD set to mature at the end of the tax year to earn stable, steady interest on the money without putting the eventual tax payments at risk. Paying taxes early, which some would recommend, is detrimental to the interest you gain by investing the amount until the taxes are due.

The second reason to invest in a Certificate of Deposit is to diversify your investment portfolio. Most investors are better off focusing on mutual funds and bonds, particularly index funds and government-backed securities. However, at a certain point, some investors may want to have a stability of income with the security of a Certificate of Deposit. Unlike equities in stocks, CD's don't fluctuate in value, and their pay-outs are stable every term. One doesn't need to worry about a Certificate of Deposit like one would in a tech stock portfolio. It's a great way for investors, late in their investment career, to move their funds out of equity and into something stable.


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