Types of Investments : Certificate of Deposit

Certificate of Deposit Basics :


The basic principle behind a certificate of deposit is very simple enough:


You lend a bank your money (minimum RM1, 000) 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 Certificate of Deposit, CD contract reaches maturity (when it ends), you get your money back. 
In Malaysia, this is also known as the term fixed deposit.


Depending on several factors, the key importance is the interest rate that is offered by the bank you use, the predominant interest rate environment, how much money you invest and how long you lock it up for. (Usually the term for Fixed Deposit in Malaysia is monthly, three month, half a year as well as yearly)


Your local bank most certainly sells CDs, but sorry to disappoint as its rates may or may not be competitive.


*Note that the interest rate differs from country to country


Therefore, when buying a CD, there are two terms you need to keep straight: 


Annual percentage yield (APY):


The yield is the total amount of interest you will earn in one year. It's conveyed as a percentage of what you invest and takes into account the way the bank compounds interest.
Annual percentage rate (APR):
The rate is simply the interest rate you will earn for that year.


Confused?


An example should help. If, say, you earned 1% per month, the APR would simply be 12% (12 months=12%). 


But the APY would be 12.68%.


Why?


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 FDIC insured for up to RM100, 000 and if you're going to invest more than that, you should purchase at least two CDs. 


However, at a brokerage house, a single CD may be insured for up to RM500, 000 through the Securities Investor Protection Corporation (SIPC), or even more through the broker's private insurance.


*Note that the sum insured for both FDIC and SPIC varies from country to country hence it is better to check with your local banks or brokerage house if not then the FDIC and SPIC of your country


The other advantage is that you know what's coming to you. Although fixed (rates does not drop nor increase) you aren't at the mercy of the market, so you can plan ahead and accordingly. Bright side is you're still earning a whole lot more than if you let that money rot away in a savings account earning a trifling 2% or less.


Cons


There are two big problems with CDs: They have miniature returns and they can lock up your money for the long haul. If you buy a five-year CD in 2001, for example, you can't get the money out any earlier than 2006 without paying a steep penalty. Even on a one-year CD, you might be penalized three months’ worth of interest (withdrawing before maturity date). 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 the difference is minimal. 


But even money funds don't get around the insignificant returns issue. While you can sensibly expect a 10% annual return from a stock mutual fund, you're going to earn about half that from a typical CD or money-market fund.


Consequently, neither investment should be used for anything other than to park money for a short period of time. 


If, say, your children 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 they are just three years old and you're just starting their college fund, then you need to be much more aggressive.