What Is an Investment CD?
An Certificate of Deposit, or CD, is one of the safest and simplest investments available, offering reliable, often federally insured, income. Selling CDs is also a means for banks to attract low cost capital, increasing their profitability.
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Function
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For an investor, the function of a CD is to park sizable chunks of money in a safe place. That is, CDs are popular more for their guaranteed return of capital than the return on capital they offer. Thus, in a turbulent period, particularly if the dollar is appreciating and inflation rates are low, investment CDs are roughly the equivalent of holding cash or putting money in a piggy bank or mattress.
Identification
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CDs are offered in denominations of $10,000, $50,000 and $100,000 with maturities of 6 months, 1 year, 5 years or more. They offer low interest rate returns that are, nonetheless, attractive compared to a traditional savings account. Unlike a savings account, however, funds in an investment CD usually cannot be withdrawn until the maturity date of the deposit.
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Features
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Usually, the interest accruing in a CD can be transferred to a separate account immediately or allowed to compound with the initial investment, an option that can greatly increase the overall effective yield. Originally, CDs paid a fixed return for the life of the investment, but more recently, CDs are being offered with variable rates. Some CDs may also be callable, meaning the depository institution can cancel the agreement and return the funds and any accrued interest within a prescribed window prior to the maturity date.
Benefits
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CDs are considered one of the safest investments because, when issued by a bank, they are backed by the full faith and credit of the U.S. government up to the limit allowed by the FDIC. The money deposited with a bank, in any form, is not passively held until withdrawn. A bank is able to offer interest on deposits only because it reinvests them in profitable investments. The risk remains that a bank will be insolvent, that is, unable to meet its liabilities, if its investments do not yield sufficient returns within a reasonable period of time. Like savings and checking accounts, Investment CDs are backed by the FDIC even if the bank itself goes out of business or is bought out.
Warning
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Not all Certificates of Deposit are issued through FDIC insured institutions---some are written by uninsured credit unions or other deposit brokers, who are usually forced to offer a higher yield in exchange for the increased risk. And, though it's rare for CDs issued by insured banks to be repackaged, the structure of a bond obtained through a deposit broker may limit an individual's FDIC coverage. CDs issued by brokers may be originated in a bank where an investor already has deposits, possibly creating exposure to the bank beyond the FDIC threshold, leaving some investments uninsured. It's therefore incumbent on the investor to explore and verify the extent to which they receive the benefit of government backing on their investment CD.
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