A Certificate of Deposit (CD) can be defined as a promissory note that is issued by financial institutions such as a bank, wherein its purchaser invests his money for a pre-defined period, at fixed interest rates. Yes, a CD does ensure fixed returns, but it has many aspects that need to be understood to gauge its suitability for investment. You also need to gain an insight into how they function.

Choosing A CD: Callable Or Conventional?

Besides the conventional CD that provides a fixed rate of interest (ROI), there is another type, called Callable CD. This is a Certificate of Deposit where the interest rate isn’t precisely fixed. Instead, it can increase or decrease over a fixed period of time. ‘Calling’ here refers to a privilege enjoyed by the issuer to cancel the CD after a certain period of time, i.e. the CD can be ‘called’. There is a fixed time period up to which these CDs are non-callable. It is very difficult to forecast when would an issuing authority will ‘call’ (redeem) a CD but usually certain indications before redeeming them are given in advance.

Maturity Of CDs

Financial institutions have different facilities on offer when a Certificate matures. Ideally, it is the investor who should claim the Certificate at the time of maturity or leave some specific instructions.

• Some investors inform the bank to automatically transfer the total amount on maturity from their CDs to the savings account in their name.

• Some banks have a policy of automatically re-investing the amount due on maturity into a new CD, if the investor doesn’t come forward at the time of maturity. This is done by issuing a new CD at the original rate of interest or at the latest applicable rates.
• Many banks have the facility where customers are reminded in advance about an impending CD that is about to mature. This is something that you would have to check at the time of purchasing a CD. Other added features could include timely interest statements and constant reminders via SMS or e-mails.

Understanding Interest Rates

The common notion is that CDs offer a fixed rate of interest. For general understanding, that does make sense. Most of the banks will offer only fixed ROI over a period of time. However, Callable or Multi-step CDs offer a bonus-centric interest rate. Here, interest rates are termed as bonus rates because they are bound to increase every time the stock markets climb. For example, some banks have variable CDs whose interest rates vary according to the Dow Jones Industrial Average Index. However, they present a riskier option when compared with conventional CDs where you receive a fixed ROI, irrespective of the stock market conditions or economic fluctuations.

Interest Payment

At the time of maturity, the owner of a CD receives two things: the principal amount which is basically the amount for which the CD was purchased and the interest generated. Now, there are some options in terms of collecting this interest. Some investors choose not to take the interest that is earned on a monthly or annual basis. They let it accrue in the certificate account, along with the principal. This means that over a period of time, you earn interest on the sum of your principal and the interest that is being generated. This is the preferred option — in it the ROI is calculated on a compounded basis.