What's the difference between a Certificate of Deposit and Stock market investment?

A certificate of deposit (CD) is a time deposit with a bank. CDs are generally issued by commercial banks but they can be bought through brokerages. They bear a specific maturity date (from three months to five years), a specified interest rate, and can be issued in any denomination, much like bonds. Like all time deposits, the funds may not be withdrawn on demand like those in a checking account.

CDs offer a slightly higher yield than T-Bills because of the slightly higher default risk for a bank but, overall, the likelihood that a large bank will go broke is pretty slim. Of course, the amount of interest you earn depends on a number of other factors such as the current interest rate environment, how much money you invest, the length of time and the particular bank you choose. While nearly every bank offers CDs, the rates are rarely competitive, so it's important to shop around.

A fundamental concept to understand when buying a CD is the difference between annual percentage yield (APY) and annual percentage rate (APR). APY is the total amount of interest you earn in one year, taking compound interest into account. APR is simply the stated interest you earn in one year, without taking compounding into account. (To learn more, read APR vs. APY: How The Distinction Affects You.)

The difference results from when interest is paid. The more frequently interest is calculated, the greater the yield will be. When an investment pays interest annually, its rate and yield are the same. But when interest is paid more frequently, the yield gets higher. For example, say you purchase a one-year, $1,000 CD that pays 5% semi-annually. After six months, you'll receive an interest payment of $25 ($1,000 x 5 % x .5 years). Here's where the magic of compounding starts. The $25 payment starts earning interest of its own, which over the next six months amounts to $ 0.625 ($25 x 5% x .5 years). As a result, the rate on the CD is 5%, but its yield is 5.06. It may not sound like a lot, but compounding adds up over time.

The main advantage of CDs is their relative safety and the ability to know your return ahead of time. You'll generally earn more than in a savings account, and you won't be at the mercy of the stock market. Plus, in the U.S. the Federal Deposit Insurance Corporation guarantees your investment up to $100,000.

Despite the benefits, there are two main disadvantages to CDs. First of all, the returns are paltry compared to many other investments. Furthermore, your money is tied up for the length of the CD and you won't be able to get it out without paying a harsh penalty.

Michael,
It is great to hear you are looking to be a long term investor.

Regarding Certificates of Deposit (CD's) and Stock market investment, Mukesh did a good job of detailing how a CD works.

For today's market CD's offer relatively low returns, typically < 2% APY for a 5 year CD. However, they are considered a very safe investment and you know how much you will get over time. If you are happy with the current CD rate of returns and you don't mind having your money "locked in" for that period of time then you are good to go.

However, you may also want to consider stocks with dividends. They offer the potential for bigger gains, BUT there is RISK. There are many companies that offer quarterly dividends (ex: energy, transportation, pharmaceutical, and even some technology companies). Roughly speaking this means the company will share its profit with the shareholder. Typically it is at a rate of 1-5% per year or divide by 4 and that is how much you get each quarter.

In addition, if the stock price goes up and you decide to sell, then you get the difference in value from what you paid and what you sold it for and you get to keep any dividends you earned during that period of time before you sold.

I do want to emphasize that stocks can be risky and although there are established companies that have paid solid 2-3% dividends for years, there is no guarantee it will continue, so do be cautious. However, with this risk there is also the potential for reward so if you pick well you may not only get a nice dividend every quarter, but the stock price may go up as well to be your "icing on the cake", :-).

Patience is the key for long term investment and to pick a good company that may be down for now, but with a positive outlook for the future. Good luck and it is nice to know you are looking at the long term.

References:
CD rates - http://www.bankrate.com/cd.aspx

Stocks - Google stocks with dividends or view some of your favorite products/companies at https://finance.yahoo.com/ and see if they offer a dividend and a good financial outlook for the future.