What Is a Certificate of Deposit Rate?
For investors who want a maximum of safety combined with reasonably good income from their savings, certificates of deposit (CDs) are a popular option. You can purchase a CD at any bank or credit union and earn better rates than with savings accounts. Plus, CDs are insured by the Federal Deposit Insurance Corporation or the National Credit Union Authority.
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Identification
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CDs are time deposits that pay a fixed (guaranteed) rate for a specified time period called the maturity. The CD rate is the amount of money the financial institution pays the investor for the use of his money and is expressed as an annual percentage of the value of the CD. In return for this fixed rate the investor agrees to leave the funds on deposit until the date of maturity.
Calculating CD Rates
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With some CDs investors elect to have the interest sent to them periodically (usually once a quarter). In this case the rate may be "simple interest" and is calculated by multiplying the annual rate by the amount of the CD and then dividing the result by four to find the amount to be paid out every three months. However, if the interest is left with the CD it is compounded. This means the interest to date is calculated periodically (commonly either monthly or daily). To do this the annual rate is first divided by the number of compounding periods (12 for monthly compounding, for example) and then the amount of the CD is multiplied by this periodic rate. The resulting amount is the interest earned during the period and is added to the CD, whereupon it begins earning more interest.
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Influences on Rates
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CD rates rise and fall along with general interest rates prevailing in the financial industry. Individual CDs pay varying rates, however, depending on several factors. The larger a CD, the better rate it usually earns. Banks and credit unions also offer higher rates for longer-term CDs, with 1- to 5-year CDs paying the most. It's also common for smaller financial institutions to offer premium rates to lure customers away from larger banks.
Penalties
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To discourage depositors from cashing in a CD before the maturity date, issuers levy penalties for early withdrawal. These are usually in the form of a reduced interest rate or the forfeiture of several months interest. For example, a $10,000 CD paying 5 percent might lose 6 months interest if cashed in prematurely, which works out to a penalty of around $250.
Interest Rate Risk
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Because CDs are insured by the federal government they carry virtually no risk that investors will lose their money. However, investors may be concerned about "interest rate risk." If a person purchases a 5-year CD, there is the chance that she will be stuck with the fixed rate while interest rates generally are rising. To safeguard against this and still get most of the benefit of the higher rates offered on long-term CDs, some investors use a strategy called laddering. The idea is to buy several CDs (say a 1-, 2-, and 3-year CD). As each CD matures it is replaced at whatever the prevailing rate is at the time. The investor thus gets good rates for moderately long-term CDs and can still benefit if interest rates go up.
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