Certificate of Deposit
A Certificate of Deposit, also known as a CD, is a savings certificate offered, typically, by commercial banks or credit unions and backed by the Federal Deposit Insurance Corporation. It specifies a particular interest rate and a particular maturity date, usually between one month and five years after purchase. Withdrawing your principal before the maturity date usually subjects you to an early withdrawal penalty.
For example, if you purchase a $1,000 1-year CD earning 3.6%, at the end of that one year, you'll earn $36 for a total of $1,036. Typically, CDs with longer time horizons earn higher rates of interest.
In general, CDs earn a higher rate of interest than savings accounts or money market accounts, but a lower average interest rate than bond, mutual funds, or stocks. Because CDs provide a guaranteed rate of return, they are recommended for money earmarked for expenses within the next five years. Their required length of time, however, makes them unsuitable for money that might be needed on an emergency basis.
A strategy known as laddering allows investors to earn the higher interest rates of CDs without substantially sacrificing the flexibility necessary for emergency funds. In laddering, you purchase a series of different CDs, bonds, or treasury bills that mature at different, regular intervals. Should you have no need of those funds when the CD matures, you reinvest in another CD. Should you need those funds, however, the regularly-spaced maturity dates provides a regular stream of accessible money.
By way of illustration, let's say you have $30,000 in savings you want to invest in CDs. You could divide that into 6 piles of $5,000 each. In January, you'd purchase a $5,000 6-month CD that came due in July. In February, you'd purchase a $5,000 6-month CD that came due in August, etc. When the first CD matured in July, you could would reinvest it and its earnings in another 6-month CD that came due in January. With this strategy you would balance a higher interest rate with regular access to funds.