Investing Options Series: Certificates of Deposit (CDs)

Posted on 21. Jun, 2006 by in Saving & Investing

Continuing the Investing Options Series, today’s topic is Certificates of Deposit (CDs) – arguably the best short-term investment.

What Are They?
A Certificate of Deposit (CD), also known as a “time deposit”, is a special type of deposit account with an interest rate higher than a regular savings account and federally insured. CDs are available at most banks, thrift institutions, and credit unions. They are available in almost any denomination starting at $1 (at popular online-only banks).

How do They Work?
When you deposit money into a CD, you invest a fixed sum of money for a fixed period of time – typically six months, one year, five years, or more. In exchange for your deposit, the issuing bank pays you interest, typically at regular intervals. Most CD purchasers can arrange to have the interest periodically mailed to them or directly deposited into another account; however, this reduces the total yield on investment because you miss out on your interest compounding.

When you cash in or redeem your CD, you receive the money you originally invested plus any accrued interest. But if you redeem your CD before it matures, you may have to pay an “early withdrawal” penalty or forfeit a portion of the interest you earned. Unless you can get a significantly greater return somewhere else it is advisable to avoid any early withdrawal of your CD deposit.

When the end of the CD term approaches, your bank or credit union will most likely contact you regarding how you wish to proceed with your CD. Most banks allow you to either withdraw the principal with your accumulated interest or roll the principal and interest into a new CD.

Different Flavors
In general, CDs are categorized according to their size. CDs larger than $100,000 are called “Large CDs” or “Jumbo CDs” and CDs smaller than $100,000 are known as “Small CDs.”

A callable CD is similar to a regular CD except that the bank reserves the right to buy back (or “call”) your CD. Due to the uncertainty these types of CDs usually command a premium interest rate. The only time a bank usually calls a CD is when it tries to protect itself from falling interest rates. For example, if your CD rate is 4.5% but interest rates fall to 2.5% then the bank is paying you more than it’s receiving from its own investments and therefore losing money by continuing to pay your high interest rate.

The last “flavor” of CD is actually an investment strategy called “laddering.” In almost any type investment the interest rates are going to be higher the longer you have to wait for your money. However, if you lock into a high rate for 5 years and market interest rates rise within that time frame, your “high rate” isn’t going to be worth much. Laddering tries to tap into the higher interest rates associated with long-term investments but also avoid being locked into rates when the market rates rise.

For example, a 3 year laddering strategy would begin with the purchase of a 1-year, 2-year, and 3-year term CD. Each year as one of the CDs reaches maturity, you can invest it in a 3-year CD – benefiting from the higher interest rates. After 3 years of this cycle, all your money will be invested in 3-year CDs but 1/3 of your investment will mature each year – allowing you to reinvest in a new CD. Using this investment strategy you can benefit from interest rate increases while also enjoying the higher rates associated with longer-term investments.

For help coming up with a laddering strategy, BankRate.com has a great little calculator which gives you conservative, moderate, and aggressive laddering strategies. When I ran the calculator for a fictitious investment, laddering helped me earn $600 more.

Short or Long-Term Investment?
In general, CDs are considered a short-term investment due to the fact that typical CDs are available in 3 month to 5 year terms. However, CDs are not as liquid as a savings account or even Money Market Accounts due to their fixed time period. The best use of a CD is saving for a certain period of time in the future such as a car purchase in two years.

Potential Risk
The largest risk with a CD is its ability, at some banks, to be called. However, avoiding a callable CD can be as easy as talking to your financial institution or reading the “Truth in Savings” booklet the bank is required to provide you.

Since CDs are a deposit account, similar to Money Market Accounts, they are insured by the FDIC for $100,000 ($200,000 if investing with a joint account) and therefore are fairly “risk-free.”

Potential Return
It’s probably safe to say that CDs represent the best short-term saving option due to their higher interest rates. For example, the one of the best deals right now on CDs is ING Direct. Their 12-month “Orange” CD has a 5.25% return as of today compared to the 4.25% APY on their savings account.

Who is this a Good Investment For?
Anyone who has time to spare. Investments always favor those who are willing to wait for their money, and CDs are no exceptions. Thanks to the influx of online banks such as ING Direct, anyone with $1 to their name can invest in a CD – as long as they are able to wait 3 months or longer. If you are saving up for a specific reason in the near future a CD might be the best way not only to get the most for your investment but also to help discipline you into saving since you won’t be able to withdraw your money (without heavy fees).

However, before you consider purchasing a CD from your bank or brokerage firm, make sure you fully understand all of its terms. Carefully read the disclosure statements, including any fine print. And don’t be dazzled by high yields. Ask questions – and demand answers – before you invest. These tips from the SEC can help you assess what features make sense for you:

  • Find Out When the CD Matures – As simple as this sounds, many investors fail to confirm the maturity dates for their CDs and are later shocked to learn that they’ve tied up their money for five, ten, or even twenty years. Before you purchase a CD, ask to see the maturity date in writing.
  • Investigate Any Call Features – Callable CDs give the issuing bank the right to terminate-or “call”-the CD after a set period of time. But they do not give you that same right. If interest rates fall, the issuing bank might call the CD. In that case, you should receive the full amount of your original deposit plus any unpaid accrued interest. But you’ll have to shop for a new one with a lower rate of return. Unlike the bank, you can never “call” the CD and get your principal back. So if interest rates rise, you’ll be stuck in a long-term CD paying below-market rates. In that case, if you want to cash out, you will lose some of your principal. That’s because your broker will have to sell your CD at a discount to attract a buyer. Few buyers would be willing to pay full price for a CD with a below-market interest rate.
  • Understand the Difference Between Call Features and Maturity – Don’t assume that a “federally insured one-year non-callable” CD matures in one year. It doesn’t. These words mean the bank cannot redeem the CD during the first year, but they have nothing to do with the CD’s maturity date. A “one-year non-callable” CD may still have a maturity date 15 or 20 years in the future. If you have any doubt, ask the sales representative at your bank or brokerage firm to explain the CD’s call features and to confirm when it matures.
  • For Brokered CDs, Identify the Issuer – Because federal deposit insurance is limited to a total aggregate amount of $100,000 for each depositor in each bank or thrift institution, it is very important that you know which bank or thrift issued your CD. Your broker may plan to put your money in a bank or thrift where you already have other CDs or deposits. You risk not being fully insured if the brokered CD would push your total deposits at the institution over the $100,000 insurance limit. (If you think that might happen, contact the institution to explore potential options for remaining fully insured, or call the FDIC.) For more information about federal deposit insurance, visit the Federal Deposit Insurance Corporation’s web site and read its publication Your Insured Deposit or call the FDIC’s Consumer Information Center at 1-877-275-3342. The phone numbers for the hearing impaired are 1-800-925-4618 or (202) 942-3147
  • Find Out How the CD Is Held – Unlike traditional bank CDs, brokered CDs are sometimes held by a group of unrelated investors. Instead of owning the entire CD, each investor owns a piece. Confirm with your broker how your CD is held, and be sure to ask for a copy of the exact title of the CD. If several investors own the CD, the deposit broker will probably not list each person’s name in the title. But you should make sure that the account records reflect that the broker is merely acting as an agent for you and the other owners (for example, “XYZ Brokerage as Custodian for Customers”). This will ensure that your portion of the CD qualifies for up to $100,000 of FDIC coverage.
  • Research Any Penalties for Early Withdrawal – Deposit brokers often tout the fact that their CDs have no penalty for early withdrawal. While technically true, these claims can be misleading. Be sure to find out how much you’ll have to pay if you cash in your CD before maturity and whether you risk losing any portion of your principal. If you are the sole owner of a brokered CD, you may be able to pay an early withdrawal penalty to the bank that issued the CD to get your money back. But if you share the CD with other customers, your broker will have to find a buyer for your portion. If interest rates have fallen since you purchased your CD and the bank hasn’t called it, your broker may be able to sell your portion for a profit. But if interest rates have risen, there may be less demand for your lower-yielding CD. That means you would have to sell the CD at a discount and lose some of your original deposit –despite no “penalty” for early withdrawal.
  • Thoroughly Check Out the Broker – Deposit brokers do not have to go through any licensing or certification procedures, and no state or federal agency licenses, examines, or approves them. Since anyone can claim to be a deposit broker, you should always check whether your broker or the company he or she works for has a history of complaints or fraud. You can do this by calling your state securities regulator or by checking with the National Association of Securities Dealers’ “Central Registration Depository” at 1-800-289-9999.
  • Confirm the Interest Rate You’ll Receive and How You’ll Be Paid – You should receive a disclosure document that tells you the interest rate on your CD and whether the rate is fixed or variable. Be sure to ask how often the bank pays interest – for example, monthly or semi-annually. And confirm how you’ll be paid – for example, by check or by an electronic transfer of funds.
  • Ask Whether the Interest Rate Ever Changes – If you’re considering investing in a variable-rate CD, make sure you understand when and how the rate can change. Some variable-rate CDs feature a “multi-step” or “bonus rate” structure in which interest rates increase or decrease over time according to a pre-set schedule. Other variable-rate CDs pay interest rates that track the performance of a specified market index, such as the S&P 500 or the Dow Jones Industrial Average.

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