Investing Options Series: Certificates of Deposit (CDs)

Certificates of Deposit (CDs)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 at http://origin.bankrate.com/brm/savings-advisers/cd-ladder.asp 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).

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