THE BASIC PREMISE behind a certificate of deposit 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 allow it to be locked up. Your local bank most certainly sells CDs, but its rates may or may not be competitive. To find the best rate, visit SmartMoney.com's Rates section. 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 a CD through a bank, your assets 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% or less. Today, a one-year CD carries an average APY of 2.9%.
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 2005, for example, you can't get the money out any earlier than 2010 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 often a better alternative. The rate may be 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 the difference is minimal. According to Peter Crane, managing editor of the iMoneyNet Money Fund Report, no retail money-market fund has ever "broken the buck" (in other words, returned less than the original contribution).
But money funds don't get around the paltry returns issue. Even the most competitive funds offer APYs of little more than 2% these days. Consequently, neither a CD nor a money-market fund should be used for anything other than to park money for a short period of time. If, say, your daughter is heading off to college within a year and you want a risk-free way to keep earning interest on the money you've saved, a CD makes sense. But if she's three years old and you're just starting her college fund, then you need to be much more aggressive.
