Certificate Of Deposit (CD)

 

Basics

In a regular savings account, checking account, or even under your bed, you can access your money at almost any time.  But if you’re willing to temporarily part with some of your money, and want to make more interest than in a regular savings account, an investment known as a Certificate of Deposit might be right for you.  Think of a Certificate of Deposit as a contract between you and your bank.  You tell your bank you won’t touch this money for a specified amount of time.  The bank then pays you an interest rate that is higher than if you simply keep this money in a regular savings account (where as you know you can withdraw it at anytime).  Beware though, if you need your money before the CD expires, the bank will penalize you.

CDs are issued by banks usually in the amounts of $1,000 or more, although some banks can offer a starting minimum of $100 or $500.  There is also something called a Jumbo CD, but this requires a minimum of $50,000 or $100,000.  With all CDs you must agree to leave your funds in the bank for a predetermined period of time.  CDs are offered for 3, 6, 9, 13, 24, 30, 36, 48 or 60 month periods.  Because of the time commitment, CDs are sometimes called time deposits.  There is no risk of losing your money when you put it into a CD since your funds are insured by the FDIC (Federal Deposit Insurance Corporation
http://www.fdic.gov/index.html , up to $100,000.

 

CD Terminology

There are different types of CDs. Here are a few of the most common ones.

  • Traditional:  The most common.  You put in a fixed amount and receive a predetermined interest rate for a specific period of time.  At the end of the term you can withdraw your money or roll it over for another term.  Most financial institutions allow you to add additional funds when you roll over the CD.  Penalties for early withdrawal can be quite severe.
  • Fexible:  Other than the traditional CDs, there are flexible CDs that allow you additional options if you need some of your money sooner.  The downside is that many of these flexible options offer lower interest rates than the traditional CDs because of the flexibility they allow.  Here are a few of the more flexible types of CDs:
     
    • Liquid:  These CDs offer you the opportunity to withdraw money without incurring a penalty, however, most banks require you to maintain a minimum balance in your account.  An exception is that after you make the initial deposit Federal law requires that the money stays in the bank for at least seven days.  The bank might extend that period, so check.  Sometimes the banks only allow a specified number of withdrawals during a month or a quarter—again, check the fine print.  The interest rate is usually less than that of a traditional CD.
    • Bump-Up:  This allows the customer to take advantage of rising CD rates, if they apply.  Generally this is only allowed once during the CD period and takes affect for the balance of the CD.  If, for example, you have a CD (what is the length of the CD, 2 years?) rate at 2.0 APY (Annual Percentage Yield, see below), after a year the bank is offering a 2.25 rate.  You would be able to receive the 2.25 rate for the remaining one year on your CD.  Before you buy a bump-up CD you should be reasonably certain that interest rates will rise before your CD matures.  And be aware some CDs are Callable.
       
  • Callable:   Sometimes banks offer CDs that can be called, or taken away before they mature after a certain specified period of time.  Banks often pay you a premium (of a quarter- to one-half percentage point) for a callable CD.  For example, you purchased a three year 4% CD with a one call protection period.  If after one year the going CD rate falls to 3.0%, the bank could call the CD.  You would receive your principal, plus 4% for the one year you had the CD.  If the rates go up, I guarantee you that your CD won’t be called!  If you decide to keep your money in a CD, the rate would only be 3.0%.


CD rates vary and are very competitive.  When you shop for a CD, the rate will be quoted as APR (Annual Percentage Rate) or APY (Annual Percentage Yield).
 

  • Annual Percentage Rate (APR):  The interest rate a bank is offering on the CD.  You will also see this term if you intend to get a loan from a bank.  This is the rate consumers pay, expressed as a simple annual percentage rate.  Or in this case, the APR the bank pays you!  Note:  If you are borrowing money (which is not what this section is about) the APR is calculated using interest, origination fees, and points (complicated and not covered here).
  • Annual Percentage Yield (APY):  This is a tool to see how much your deposit will earn over the multi-year life of the CD as your money compounds.  This will tell you how much you are really making on your money over time.

 

 

Are CD’s The Right Investment For You?

In order to see if a CD is the correct way to invest for you:

  • Determine when you will need all or part of your cash.  Will you need to access this if times get tough?  Can you safely leave the amount you plan to invest for the entire time you take out the CD?
  • What do you think will happen to interest rates?  If you think that rates are rising (which usually happens during inflation) invest in a short term CD.  That way, if rates do rise, you can take advantage of the higher rates.  On the other hand, if you think that rates are falling (usually when the economy is on a do wnswing), a longer-term CD is better.  This way you lock in a fixed rate and if the rates are further reduced you will still be earning a higher rate.  It is always important to look at investments in both the long and short term.  Also, you need to be aware of the broader economic climate both in the U.S. and around the world.
Again, if you withdraw your money before the CD comes due, you will incur a substantial penalty.  If you are at all uncertain regarding the length of time you can invest you might use a technique called laddering (more advanced).

 

 

Laddering

Instead of investing all your money at one time, you divide your total available cash into equal parts and invest each part in CDs of varying duration.  For example, you want to invest $3,000 in a CD. Instead, you invest $1,000 in a one-year CD, $1,000 in a two-year CD, and $1,000 in a three-year CD.  Each time one of the CDs matures, you can either take the cash (penalty free—since it has matured) or re-invest it in another three-year CD to keep your ladder in place.

Here are a few sites to see what some current CD rates.
CDs are a more sophisticated and complicated way to save.  Make sure you check with your bank first.  CDs can, however, be an excellent part of your saving strategy.