Banks are constantly trying to “seduce” people into putting their money into the bank. For this, they offer their clients to pay them for doing so. This is known as a deposit.
Are certificates of deposit a good investment option for you?
The answer is not simple; it depends on the bank, the terms they offer and you as an investor. On the positive side, CDs give people a steady and predictable income in the form of interest rate. On the downside, it “locks” your money for a set period of time – three months, six months, a year, etc.
What are CDs, how do they work, what are their pros and cons, how many types are there?
What Are Certificates of Deposits (CDs)?
A certificate of deposit (CD) is a contract between a bank and a depositor for a fixed period of time. The latter is called term. The depositor entrusts his money to the bank and for this, it pays an interest rate to the deposit owner.
Usually, people buy deposit accounts because they have some spare money they do not need in the near future.
If the term of your CD is one year after it expires the bank will pay the interest rate on the money. A deposit owner should pay taxes on the returns unless the account is tax-free or tax-deferred.
Bear in mind that CDs are low-risk and low-return investments and are not suitable for people who need cash at the moment.
Well, if your bank is insured by the Federal Deposit Insurance Corporation (FDIC) and is under $250,000, then your deposit is also insured. If the bank goes bankrupt, the FDIC will give your money back.
There is nothing as helpful as a good example.
Let's say, John has saved $5,000 which he does not need in the near future. Then, he decides to buy a CD at a 2.5% compounded interest rate. The term of the deposit is 2 years. If John withdraws money from his deposit account before the end of the second year, he will have to pay a penalty.
For the first year, John will receive $125 in interest (5,000×2.5%). For the second year, he will receive $128 (5,125×2.5%), and the whole amount of money after the maturity date will be $5,253.
How Is The Interest Rate Distributed?
It depends on the bank and the contract you have signed. There are CDs that offer the interest rate to be paid each month or once every three months. The money is deposited into the account. More often, banks pay the interest they owe the account holder when the term ends.
Sometimes, which is tricky, CD's rollover. This means that your contract is automatically renewed and your CD extends for a new term. The interest rate changes, however, and usually equals the current market one. If this is the case, end the contract on the day it expires and open a new one at better terms.
My advice is to know very well what kind of CD is your deposit account and all the details concerning penalties, interest rate, term, rollover, etc.
CD laddering is a very common strategy.
The deposit owner benefits from high-interest rates usually typical for long-term CD and has access at the same time to his funds. Simply said, you get high rates without “locking” your money for 3, 5 or more years.
The process of laddering includes buying several CDs with different terms. Instead of having one which rolls over at the end of the set period, you can have several deposits.
Let's take a look at John again. He has $5,000 extra cash, but he's not sure if he won't be needing this money in a year or two. Therefore, he uses the above-mentioned technique. He opens 5 CDs and invests $1,000 in each one of them. The first one has a year maturity, the second – a two-year term. The third has three-, the fourth four- and the fifth five-year terms respectively.
After the first CD expires, John opens a new five-year deposit. Then, next year his second deposit expires and he buys a new five-year deposit. In this way he ensures that each year he has a deposit that matures, taking advantage of the higher interest rates.
Disadvantages And Risks Related To CD
Early Withdrawal Penalty
As we mentioned, CDs have a preliminary set framework – term and interest rate. Unlike money market account, in case you should you withdraw money before the term ends, this might cause a penalty. The amount of this penalty depends on the money you have withdrawn as well as the deposit and the bank.
Usually, the institution that issues the deposit charges several months' worth interest. For instance, a 12-month CD's penalty might be three months of the annual interest on the money.
Keep in mind:
Sometimes there is a Grace period during which early withdrawals are not sanctioned.
Ultimately, this is the greatest risk to CDs.
This is particularly risky when you have a Traditional CD with a fixed rate and early withdrawal penalty. Let's imagine the interest you earn is 2% on the amount of money. However, this same year inflation rises by 2%. This means that you have not made any profit whatsoever. Sometimes the interest rate could be even lower (they have been pretty low recently, close to 1%) than the rate of inflation.
If a bank goes bankrupt, this is not a great day for deposit holders. Yes, the FDIC insures most deposits; it depends on the CD issuers as well as the amount of money. As previously mentioned, the FDIC covers only deposits up to $250,000.
Types of CDs
This is the most common type of CD. Its characteristics are:
- Fixed term (3 months, 6 months, a year, etc.)
- Fixed interest rate (for example, 1.5%)
- If you withdraw before the maturity ends – you have to pay a penalty.
- Protection by the FDIC if the deposit does not exceed $250,000
Stockbrokers and financial institutions may also offer deposits and they are called “brokered”. Actually, they represent a bank's offers, including those of online banking institutions. As a rule, brokered CDs are high-return, riskier and with a longer term.
In addition, not all of them are FDIC insured and might require a fee when purchasing the account. Moreover, sometimes there is a minimum limit of, for example, $10,000 to open an account.
CDs which do not offer a fixed interest rate are called variable- or flexible-rate CDs.
These usually carry a higher risk and a potential for greater returns. Normally, a person would buy a variable-rate CD with a longer term. There is an option of “bumping-up” which allows the account holder to adjust the interest rate according to market conditions. It's important to know how many times you can “bump-up” and when. Be sure to know all details, including when the interest is distributed.
I recommend this type to people who know the market very well. This is important because a person should know when exactly to adjust the interest rate and benefit the most.
Liquid CDs are deposits which allow the account holder to pull out some of the money without paying a penalty.
In order to take out money without an early distribution penalty, however, you have to follow some withdrawal limits. For this reason, these CDs offer lower interest rates.
The typical thing about this type is that it does not pay interest annually but rather distributes the amount after the end of the term. Banks offer zero-coupon CDs at great discounts, but you will have to pay taxes on the income. These CDs tend to offer higher rates.
Usually, brokers offer these types of CDs. The specific thing is that they contain a call feature.
What is that?
If the deposit has a term of 3 years, the bank might decide to end the contract prior to expiration.
Of course, there is a protection period, for example 6 months. If the bank does that, they have to pay the owner his money as well as the interest earned during the period.
Is A CD For You
If you are wondering whether to open a CD, you should consider the following:
- Are you going to need the money in the near future? Remember, a CD “locks” your money for a preliminary set period of time.
- Do you want to invest short-term or you have plans in the long-run?
- Do you prefer lower returns and lower risk or you want to make a higher profit for a shorter period of time?
- Are you aware of the potential risks that deposits carry?
Answer these questions and then decide your next steps!