What are CDs?
CDs, Certificates of Deposit, are fixed-income investments issued by banks and other lenders, and insured by the FDIC up to $100,000 ($250,000 on retirement accounts).
Here’s how it works: You give the bank a fixed amount of money for a fixed term. The bank gives you the principal, plus a fixed amount of interest. When the term expires, you receive your principal and accumulated interest. Unfortunately, you are responsible for paying taxes on the interest you earn.
Types of CDs
Once you decide to purchase a CD, you have to decide which type of CD to buy. There are several CDs you can choose from:
A traditional CD is the old standby. You choose a fixed amount of money that is invested for a preset term and interest rate.
Afraid of rising interest rates? A bump-up CD allows you a one-time option to bump up your interest rate. Let’'s say you purchased a three-year CD and then a year into your CD, interest rates rise. With your bump-up CD, you can bump up that interest rate. The downside to this type of CD is that your initial interest rate will be lower than that of a traditional three-year CD.
Afraid of penalties? Consider a liquid CD. You can withdraw money without penalty. Your interest rate will be lower for this privilege. Federal law mandates that CD money must stay in the account for seven days prior to withdrawal without penalty. Banks are allowed to set the penalty-free withdrawal period for any time after that.
Want to avoid irksome interest payments? Think about zero-coupon CDs. You buy the CD at a deep discount to par value (the amount you’ll get when the CD matures). The word “coupon” refers to an interest payment. Zero-coupon means no interest payments. You do not receive any interest until the bond matures.
Not afraid of interest rate risks? Then think callable CD. The bank can repurchase its CD from you after a stated interval. Banks usually call CDs in when interest rates drop. The bank reissues the bonds it calls in at a lower interest rate. The upside is that you get a higher interest rate because of the call option embedded in your CD.
The Pros and Cons of Investing in a CD (as opposed to savings, stocks, money-market accounts, 401Ks, etc.)
Your money is in a safe place with higher interest than it would get in a savings account.
The FDIC (Federal Insurance Deposit Corporation) insures CDs up to $100,000 so you can be assured that you will get the money back when the CD matures.
There are several different types of CDs available that offer various perks and assurances.
CDs are lower risk, and therefore lower yield. While you can be assured that your initial investment is safe, you don’t have the possibility of earning greater amounts of money that you may earn with higher risk investments.
The CD is susceptible to market fluctuations. While the economy is doing well, interest rates will be higher.
There is a penalty charged (unless you have a brokered CD) if removing the money earlier than the term of the CD.
Despite a CD’s relatively high and safe returns, inflation can still have an effect. Do your research and protect your purchasing power.
With CDs, you’re locked into a set period of time. The shortest CDs are usually six months and offer the least amount of interest. The sweet spot right now appears to be the 12 and 18-month CDs, though if you’re willing to lock it in for 60 months, you will be handsomely rewarded.
Opening a CD
If you decide you want to purchase a CD, you should compare rates and terms offered by different lenders. You may find that online lenders have a better rate of return than a traditional bank. Local and online credit unions are also worth looking into.