A certificate of deposit is not a physical piece of paper issued by a bank or credit union. It is an account set up under certain terms. The basic elements include the amount of deposit, the rate of interest (or return), the frequency of calculating interest, and the time frame (or term) marking the duration of the account. The deposited money and its earnings are typically "locked away" from the investor until the maturity date.

For a basic CD, the term is a predetermined period of time, such as three months, six months, one year, or five years. In exchange for not withdrawing the investment or earnings during the term, the investor receives a fixed rate of interest – an interest rate that does not change for the entire period. Sometimes, a minimum deposit amount is required, with larger deposits paying higher interest rates.

Penalty fees usually keep investors from withdrawing money from the account before the agreed-upon date. Because the bank often uses money from CD accounts to perform other activities, such as lending, the bank is in a difficult position if asked to return the money early. Penalty fees compensate the bank for drawing from other funds to pay the investor before the end of the term.

How much are the penalty fees? The federal government, which insures many CD accounts, has required a penalty of at least seven days' worth of simple interest on money withdrawn six days or less after the initial deposit. Beyond this minimum, CD issuers are free to set their own penalty limits, and the penalties can be substantial.

Short-term CDs, such as those with a term of 30 days, may pay no interest at all if the money is removed prior to the maturity date. CDs with maturity dates of two to 12 months often impose penalties equivalent to three months' worth of interest. CDs with a maturity date longer than three years may impose a penalty of 180 to 365 days of interest for early withdrawal. There are exceptions, however. If the account holder dies or is declared mentally incompetent, fees may be waived. Fees may also be waived if the CD is in a tax-deferred retirement account, such as a 401(k) plan or IRA.

Not only is the rate of interest typically greater for larger deposit amounts, it is often greater for longer terms, as well. The rate of interest on a 30-day CD, for example, is generally less than the rate on a one-year CD. The longer an investor is willing to remain "hands off," the greater the overall yield can be. An exception is when there is an inverted yield curve. At this time, short-term term CDs may pay higher rates than long-term CDs because the market is less confident about long-term purchases. (Read The Impact Of An Inverted Yield Curve to find out what happens when short-term interest rates exceed long-term rates.)

Some investors do not reinvest the CD's interest when it is calculated. Instead, they receive regular interest checks from the bank or credit union, providing a steady stream of income. Not reinvesting the money into the CD account has the downside of reducing the overall yield that is possible through compounding. Investors who want to maximize returns should reinvest the interest each time it is calculated so the interest will earn interest, too.

Next: Certificates Of Deposit: Bells And Whistles (Part I) »


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