CD Investment Guide
About the CD Guide
In this guide, we cover the basics of the certificate of deposit: what CDs are; which investors are best suited to which CD types; the interest and redemptions features of CDs; and where you can find the best CD rates. While this guide provides an overview and general advice, we encourage you to seek the advice of a qualified financial advisor in order to receive specific information about your individual financial situation.
What is a Certificate of Deposit
A certificate of deposit is a time deposit. In exchange for keeping money in the account for the duration of the term, a bank (or savings and loan or credit union) guarantees the depositor a specific rate of interest. This is different than savings, checking, or money market accounts, whichare demand accounts. The owner of these types of accounts can demand (withdraw) his or her money at any time for any reason.
The Federal Deposit Insurance Corporation (FDIC) insures CDs that are purchased from a bank or brokerage house. The National Credit Union Administration (NCUA) insures CDs that are sold by credit unions. Most CDs pay a fixed rate of interest, but some pay a variable rate. In general, the higher the investment amount and the longer the term, the higher the rate that is paid by the issuing bank or credit union.
Why Choose a CD?
Certificates of deposit have a place in almost every investor's portfolio. From a young college graduate just starting out to a married couple nearing retirement, CDs offer several features that are well-suited to investors in every age and income bracket.
Young people in their 20s and 30s can benefit from CDs in order to save for a down payment, a car, or the proverbial rainy day. While short-term traditional CDs typically pay only ½ to 1% more than traditional savings accounts, they offer a way to teach financial discipline that bank accounts don't. For example, young people who are still grappling with immediate gratification when it comes to purchasing impulse items may learn that the benefit of disciplined saving allows them to obtain their goals earlier.
For those approaching middle age, CDs, especially those that offer higher yields, can play a big role in saving for retirement. While most financial planners will advise people to keep at least a portion of their retirement accounts in stocks to enable growth, CDs can provide a measure of security in uncertain economic times.
Finally, for those who've already retired and are taking mandatory distributions from individual retirement accounts, 401(k) accounts, and pensions, CDs provide a safe method of saving.
Most CDs, however, have early withdrawal penalties. It's important to make sure that there's enough cash in a demand account to meet day-to-day expenses and any small emergency expenses. Otherwise, the higher rate of interest that is paid on a CD will be lost in early withdrawal penalties.
Interest Features of CDs
Interest features of CDs include fixed rate, variable rate, contingent rate, and zero-coupon. Traditional CDs offer fixed rates that pay either simple interest or compounded interest. If possible, always choose a CD (or any investment) that pays compounded interest. When interest is compounded, it is credited to the account and becomes part of the principal. Each time interest is calculated, it's calculated on an ever-larger amount.
The bump-up CD is a relatively new type of CD. It allows the owner to take advantage of an increase in interest rates if it occurs before the maturity date of the CD. For example, if the bank offers 2% on a new 2-year CD and you're getting 1.75% in your current 2-year CD, you can ask the bank to pay 2% for the remainder of the term. Note that a CD with the bump-up feature will often pay less than a CD without this feature, as the bank will want to reduce its risk. This type of CD is typically best for those who purchase longer term CDs but want to protect themselves against the loss of interest income in an environment of rising interest rates.
Liquid CDs are also relatively new. They combine the time deposit aspect of a traditional CD with the withdrawal aspect of a demand account. Most banks require that a minimum balance be kept in the account and may limit the number of withdrawals that can take place during the term. But for those looking to create a liquid emergency fund, the liquid CD is the often the best way to go.
Zero-coupon CDs are available as an investment option. These CDs are more of an investment option than a savings option because they are purchased at a discount to par and are only worth the entire face value at maturity. They function very much like zero-coupon bonds, but provide a much greater amount of safety because they are FDIC insured. Before purchasing a zero-coupon CD, it's always wise to discuss your overall financial goals and objectives with a qualified financial planner. Zero-coupon CDs trigger a tax liability each year even though the amount earned is not paid.
Finally, a high-yield CD is a good choice for those who have a large amount of cash that would earn significantly more in a CD than a standard demand account. Always make sure that a high-yield CD is sold by a reputable broker and does not just provide "teaser rates".
Redemption Features of CDs
There are three ways in which a CD can be redeemed: when it reaches maturity, if it is callable, or early withdrawal.
CDs that are redeemed at maturity are the most common type of CDs sold. They are contracts that exist for a specific term and expire at the end of that term. At that time, the owner has the option of cashing out the CD or rolling it over into a new CD.
Callable CDs pay a premium over the traditional CD. The bank can at any time call the CD away from the owner. This is most often done when interest rates drop. For example, a callable CD with a two-year term that pays 2% interest may be called away from the owner if the bank offers two-year CDs at 1.75% before the maturity date. Of course the bank will refund the premium and all interest earned, but the owner may be left searching for another CD in an environment of lower rates. This type of CD is really only for sophisticated investors who purchase it with the help of a financial planner or tax specialist.
Financial planners and those who sell CDs will always want to make sure that a person buying a CD has enough liquid cash in demand accounts to cover daily necessities and emergencies. Early liquidation of a CD normally results in penalties. While the bank that issued the CD will determine the penalties, a loss of interest and sometimes principal can occur upon early withdrawal.
Best CD Rates
Regardless of your financial situation, you want to find the best rates available for the CD you purchase. In general, smaller and online banks will pay higher rates than larger banks, and larger deposits will earn more than smaller accounts. But don't let the rate influence the CD you buy.
While the rate is important in your overall financial plan, safety and the type of CD are more important. Just as it's important to diversify your stock holdings, it's critical to make sure that any CD is right for you.
While we've covered the basics of CD investing here, CDs should only be part of a long-term investment strategy. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.