Certificates of deposit (CDs) are a guaranteed investment where you pay a set amount for the CD and the bank will guarantee you will get your original money (principal) back when the CD matures plus a fixed interest rate which will never change. Because you are agreeing to leave the money with the bank for a certain amount of time, CDs tend to pay a higher interest rate than a normal savings account. The length of time from when you buy the CD to maturity is called the “term”.
Are CDs safe?
These investments are very safe – they are guaranteed by the financial institution you buy them from and more importantly the FDIC will guarantee any CDs you own up to $250,000 for 2009. This will drop back down to $100,000 person starting in 2010. $100k coverage is still pretty good!
What do I need CDs for?
CDs are considered to be fixed income investments. Even if you own mostly stock mutual funds it helps to have some of your money allocated to a safer investment to help weather any bear markets. CDs are also useful if you are saving for a particular large purchase (ie a car) where you know you don’t need the money for a known amount of time.
Watch out for penalties
One thing to be very aware of is early withdrawal penalties – these are usually several months worth of interest so if you buy a CD then make sure you buy a term that is appropriate for you.
Another good use for CDs is for your emergency fund. If you have 1 year of expenses, then you should be able to put half of the emergency fund in a 6 month CD.
Certificates of deposit are not long term investment by definition – most terms are from 30 days to 5 years although with the auto-renewal feature, you can keep your money invested in CDs indefinitely.
They might be a bit riskier but here is more information on high yield CDs.