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Certificate of Deposit (CD) |
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WIKI ANALYSIS
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This article is a part of Wikinvest's Personal Finance section and Guide to Investing. Please contribute or edit to improve it. |
The chart to the left is for 6 month CDs.
A certificate of deposit, or CD, is an interest-bearing deposit account. However, unlike a savings deposit account in which the interest rate may fluctuate, a CD investment is guaranteed a specific rate of return.[1]
The interest rate on a CD is higher than on a savings account because the investor, in exchange for receiving a guaranteed rate of return, commits to a specified period of time (the "term") during which he will not withdraw his investment. Common terms for CDs range from 30 days to 5 years. With most CDs, withdrawing any of the investment before the end of the term (the "maturity date") will incur an often substantial early withdrawal penalty.[2]
Benefits of Opening a Certificate of Deposit
- A "higher-return" deposit account: After checking, money market accounts and savings accounts, CDs are the next rung up on the investment ladder: CDs generate a higher return than the traditional deposit accounts, yet they do not have the volatility and risks associated with stocks, annuities, and other types of investments.
- Secured Investment: Most CDs are insured. To be safe, always verify that the CD you are investing in is FDIC insured (banks) or NCUSIF insured (credit unions). If a financial institution fails, these CD investments are secure up to $250,000.00.[3][4]
- Pre-calculated Returns: CDs are nearly risk-free. You will get a pre-determined rate of return, no more or no less, since even if the bank goes under the deposit is insured by the FDIC.
Drawbacks of Opening a Certificate of Deposit
- Higher Initial Investment Outlay: The minimum amount required to open a CD is usually higher than what is required for a savings account. Also, acquiring the higher interest rates requires a more substantial initial investment.
- Minimal Returns as an Instrument for Investment: Shorter term CDs will offer lower rates of return than those with longer terms. However, with longer term CDs, if interest rates go up during the term, you may be stuck earning a low interest rate until the CD matures.
A CD will not give you substantial returns compared to most other types of investments. Investopedia explains succinctly: "CDs are generally considered short-term, low-risk, interest-paying storage for capital until a more profitable investment can be found." CDs offer steady interest earnings, but not high returns.
- Early Withdrawal Penalties: If you need access to your funds before the CD's maturity date, an early withdrawal penalty will be assessed. Be forewarned: The penalties can be considerable. A Bankrate survey found that, beyond losing some or all of the CD interest by making an early withdrawal, investors often lost a portion of their principal investment too.
How to Get the Most out of Your Certificate of Deposit
- Go Shopping: As with everything else you spend money on, compare CD rates to get the most for your money. Rates differ among banks and credit unions, so shop around for that high rate.
- Be Realistic About the Term: If you don't have a lot of money to invest, and certainly if you know you may need access to the money in the near future, start by purchasing shorter term CDs. It's easier to trust that you won't need the funds for 60 days or six months than to have that same confidence in what your financial situation will be four or five years down the line.
- Check If It's Insured": Some CD's that may have higher interest rates carry more risk as they are not insured by the FDIC. An uninsured CD is susceptible to bank failure where you get nothing. When looking for the best paying CD's, it is likely the ones with the highest rates may not be insured. [5]
- Look for "Opt-up" or "Bumps": Investigate CDs that allow you to unlock to a higher interest rate once, or even multiple times, if interest rates should rise during the term of your CD. For example, Bank of America offers a CD that allows you to relock into a higher rate one time during your term if interest rates rise.[6] Anchor bank offers a 24-month CD that allows you to unlock for higher interest rates every six months.[7]
However, with opt-up and bump offers, be aware that you won't necessarily get a bump up as high as the interest rate has actually risen. Also, the minimum investment for these accounts is often higher than with traditional CDs.
- Stagger Your CD Investments: If you invest in multiple CDs, you can stagger your investments so that you will regularly have one or more CDs maturing in case you need the cash. You might, for example, invest in three CDs, each with a different term such as six months, one year, and 18-months. Alternately, you may purchase the CDs at different times which will also stagger your maturity dates.
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What To Do When Your Certificate of Deposit Matures
When your CD maturity date nears, the bank or credit union will notify you. You can then do one of two things:
- If you want to remain in the same investment, do nothing and your investment will automatically roll over (be reinvested) in a CD with the same term.
- If you need the money, or if you'd like to invest it elsewhere, you can direct the financial institution to close the CD on the maturity date and have the money transferred to your savings or checking account.
References
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