Series of Investment Options: Certificates of Deposit (CD)

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 a higher interest rate than a regular savings account and is federally insured. CDs are available at most banks, savings institutions, and credit unions. They are available in almost any denomination starting at $1 (at popular banks online only).

How do they work?

When you put money into a CD, you invest a fixed amount of money for a fixed period of time, usually six months, one year, five years, or more. In exchange for your deposit, the issuing bank pays you interest, usually at regular intervals. Most CD buyers can arrange to have the interest mailed to them periodically or deposited directly into another account; however, this reduces the total investment return because you lose the compounding of your interest.

When you cash in or redeem your CD, you receive the money you originally invested plus any increased interest. But if you redeem your CD before it expires, you may have to pay an “early withdrawal” penalty or lose some of the interest you earned. Unless you can earn a significantly higher return elsewhere, it’s a good idea to avoid any early withdrawal of your CD deposit.

As the CD term nears its end, your bank or credit union will most likely contact you to find out how you want to proceed with your CD. Most banks allow you to withdraw the principal with your accrued interest or transfer the principal and interest to a new CD.

different flavors

In general, CDs are classified according to their size. CDs over $100,000 are called “Large CDs” or “Jumbo CDs” and CDs under $100,000 are known as “Small CDs.”

A callable CD is similar to a regular CD except that the bank reserves the right to repurchase (or “take back”) your CD. Due to uncertainty, these types of CDs generally carry a higher interest rate. The only time a bank typically asks for a CD is when it’s trying to protect itself from falling interest rates. For example, if the rate on your CD is 4.5% but interest rates drop to 2.5%, then the bank is paying you more than you get back on your own investments and therefore you are losing. money by continuing to pay your high interest rate.

The latest “flavor” of CDs is actually an investment strategy called “scaling.” In almost any type of investment, interest rates will be higher the longer you have to wait for your money. However, if you maintain a high rate for 5 years and market interest rates rise within that time period, your “high rate” won’t be worth much. Scaling attempts to take advantage of the higher interest rates associated with long-term investments, but also avoids being taxed when market rates rise.

For example, a 3-year ladder strategy would start with the purchase of a 1-year, 2-year, and 3-year term CD. Each year when one of the CDs matures, you can invest it in a 3-year CD, benefiting from higher interest rates. After 3 years of this cycle, all of 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. By using this investment strategy, you can benefit from increases in interest rates while enjoying the higher rates associated with longer-term investments.

For help with a scaling strategy, BankRate.com has a great little calculator at http://origin.bankrate.com/brm/savings-advisers/cd-ladder.asp that gives you conservative, moderate, and moderate scaling strategies. aggressive. . When I ran the calculator for a fictitious investment, scaling helped me earn an additional $600.

Short or long term investment?

CDs are generally considered a short-term investment due to the fact that typical CDs are available in terms of 3 months to 5 years. 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 to save for a certain period of time in the future, such as buying a car in two years.

Potential risk

The biggest 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 “The Truth in Savings” brochure that the bank should 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 invested with a joint account), and therefore fairly “risk-free” .

potential return

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

For whom is it a good investment?

Anyone with time to spare. Investments always favor those who are willing to wait for their money, and CDs are no exception. Thanks to the influx of online banks like ING Direct, anyone with $1 to her name can invest in a CD, as long as he can wait 3 months or more. If you’re saving for a specific reason in the near future, a CD might be the best way to not only get the most out of your investment, but also help discipline you to save, since you won’t be able to withdraw your money (no hefty fees). .