Although a bank certificate of deposit (CD) will essentially lock up your money for a given period of time, it can be an attractive savings/investment device because CDs normally offer higher interest rates than standard savings accounts. Like savings accounts, CDs are also virtually risk-free because they are insured by either the FDIC or NCUA.
Banks, knowing that they will have control of your money for a particular, often lengthy, period of time, are normally willing to pay a higher interest rate on money kept in CDs rather than in savings accounts. Furthermore, CDs with longer terms are more likely to receive higher interest rates. For example, a particular savings account may have an interest rate of 3.00% while a 12-month CD pays 4.00% and a 24-month CD pays 4.50%. It is also common for the interest rate for CDs to be fixed, whereas the interest rate for a savings account could vary over time. The interest rate for a CD is commonly referred to as the annual percentage yield, or APY.
When a buyer establishes a CD, he/she may have a choice of receiving periodic interest disbursements or allowing the interest to accrue within the CD. If he selects to receive disbursements, the interest that the CD earns each period (e.g. month) will be sent to him automatically by check or by electronic deposit. If he allows the interest to accrue, the interest payments are added to the CD, and they will compound (the interest from previous months will itself earn interest). Consider the following example in which a person deposits 25,000 to a 1-year CD with an APY of 4.00%. In the first case the investor opts to withdrawal the interest while in the second case he allows the interest to accumulate each month.
|Action On Interest||Principal||Term||APY||Monthly Disbursement||Ending Balance||Total Interest Earned|
As you can see, allowing the interest to accumulate/compound will result in slightly higher overall earnings.