THE BASIC IDEA behind a certificate of deposit (CD) is simple enough: You lend a bank your money (as little as $100, but often $1,000 or more) for a specific amount of time (up to five years). In return, you receive a set amount of annual interest on the loan, and when the CD contract reaches maturity (i.e., when it ends), you get your money back.
How much interest you earn is the key. And that depends on a number of factors -- which bank you use, the prevailing interest-rate environment, how much money you invest and how long you lock it up for. Your local bank most certainly sells CDs, but its rates may or may not be competitive. To find the best rate, visit here. It has a list of rates currently offered by banks nationwide.
When buying a CD, there are two terms you need to keep straight: annual percentage yield (APY) and annual percentage rate (APR). The yield is the total amount of interest you will earn in one year. It's expressed as a percentage of what you invest and takes into account the way the bank compounds interest. The rate is simply the interest rate you will earn for that year, without the effect of compounding interest.
Confused? A simple example should help. If, say, you earned 1% per month, the APR would simply be 12%. But the APY would be 12.68%. That's because the APY takes into account the compounding effect on the interest you earned earlier in the year.
Pros
For conservative investors, the best thing about CDs is that your money is safe. When you purchase one through a bank, your total assets there are insured by the Federal Deposit Insurance Corporation (FDIC) for up to $100,000. At a brokerage house, a single CD may be insured for up to $500,000 through the Securities Investor Protection Corp. (SIPC), or even more through the broker's private insurance.
The other advantage is that you know what's coming to you. You aren't at the mercy of the market, so you can plan accordingly. And you're still earning more than if you let that money rot away in a savings account earning a paltry 1%.
Cons
There are two big problems with CDs: They have tiny returns, and they can lock up your money for the long haul. If you buy a five-year CD in 2003, for example, you can't get the money out any earlier than 2008 without paying a steep penalty. Even on a one-year CD, you might be penalized three months worth of interest. That's why a money-market fund is usually a better alternative. The rate may be slightly lower, but you can withdraw your money whenever you see fit.
Granted, a money-market fund is not considered as secure as a CD, but no retail money-market fund has ever returned less than the original contribution.
But even money funds don't get around the paltry returns issue. While historical returns suggest you can expect an average 10% annual return from a stock mutual fund, you're probably going to earn far less than that from a typical CD, and less than 2% from a money-market fund. Consequently, neither investment should be used for anything other than to park money for a short period of time.
