Certificate of Deposit - Explained
What is a Certificate of Deposit?
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Table of ContentsWhat is a Certificate of Deposit?How Does a Certificate of Deposit Work?Academic Research on Certificate of Deposit
What is a Certificate of Deposit?
Certificate of Deposit is a financial document or contract offered by a financial institution normally with a fixed return over a particular period of time. US is the pioneer country that started issuing a Certificate of Deposit back in 1961. This financial security can be exchanged in a secondary market. With a Certificate of deposit, an investor is in a position to sell the securities before the maturity date although its liquidity is lower compared to other types of assets like shares.
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How Does a Certificate of Deposit Work?
CDs are the most commonly used for creating secured savings because of the low-interest rate. In addition to that, there are no fees attached to the investment. The CD limits the holder from withdrawing cash or funds in the CD with remitting a penalty. Usually, the holder is expected to leave the money with the bank for the whole term. It is also important to note that the terms for most CDs range between 3months to 5 years. In terms of getting the returns, the long-term CDs pay more than the short-term CDs, a situation which is always attributed to the risks of market uncertainty. CDs and banks are mostly insured by the Federal Deposit Insurance Corporation up to the tune of $250,000. There are a number of special CDs with special features, including:
- Step-Up Certificates of Deposit This enhances the yearly percentage increase in the yield after a given period.
- Bump-Up Certificate of Deposit - This type enables the owner to ask for a higher APY in the case that the bank adjusts its APYs on newly given CDs.In most cases, the rates can only be increased once or twice during the entire period. It is because of this benefit that these CDs carry a lower APY compared to fixed-rate CDs.
- Liquid Certificates of Deposit This gives the owner the capacity to withdraw their funds which enhances their liquidity because they can cash in the CD before maturity without paying a penalty. Because of the high liquidity, the CD mostly pays a lower APY compared to fixed-rate CDs.
- Jumbo Certificate of Deposit - This is one of the pioneer CD containing little investment or purchase price. Generally, they have a higher APY compared to non-jumbo CDs
- Individual Retirement Account Certificate of Deposit - It is one of the traditional CD that has the advantage of receiving favorable tax treatment.
The trading of Certificate of deposits is not very common except in Latin America countries where it remains very active. The holders of CDs tend to create a platform to check on some of the risks that come with investing in long-term CDs.Laddering, in this case, implies investing reasonably in Cds with different terms. Short term securities are usually reinvested in incrementally longer Cds as they mature. As a result of this, the holder is in a position to maintain staggered ownership of CD structure.