Congratulations! If you are reading this article, you have saved money, an awesome feat, and are now ready to invest it. You are considering investing in a CD (Certificate of Deposit). You can’t help but wonder - what is a CD, and what are the pros and cons of investing in a CD? What types of CDs are out there and which CD should you buy?
- What are CDs? CDs are fixed-income investments issued by banks, 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 term (that’s a predetermined amount of time). The bank gives you the principal, plus a fixed amount of interest. When the term expires, you receive your principal and accumulated interest.
- How to buy CDs. Once you decide to buy a CD, decide on how you want to buy a CD. CDs can be purchased through either a bank or brokerage firm. Some banks have regulations that require you to physically come in to open a CD account. Other banks allow you to open a CD account online.
- Duration of term. Although, CDs can be purchased for any amount of time, most people prefer to buy CDs having a duration between three months to five years. The old rule of thumb was that a longer duration meant a higher interest rate. More recently we see instances where a 6 month CD pays a higher rate than a 5 year CD. In today’s interest rate climate, it’s advisable to limit your duration to 5 years.
- The big advantage to buying a CD is that you earn a higher rate of interest than with a savings account or a money market account. The disadvantage to CDs is they lack liquidity. Once you tie up your funds, they are no longer yours for the specified time period.
- Need cash in an emergency? Don't cash in your CD before it matures! You will lose interest and possibly principal. Federal law mandates that when CDs are cashed out early, they are subject to a minimum penalty of seven days' simple interest on amounts withdrawn within the first six days after deposit.
- Banks are allowed to set their own penalties for early withdrawal from a CD, and they do! So be vigilant when researching penalties for cashing in your CD early.
- Once you decide to purchase a CD, you have to decide what type of CD to buy. There are several CDs you can choose from.
- A traditional CD. The old standby is the traditional CD. When you buy this CD, you choose a fixed amount of money which is invested for a preset term and interest rate.
- Afraid of rising interest rates? Buy a bump-up CD! As its name suggests, a bump-up CD allows you a one-time option to bump up your interest rate. Let’s say you purchased a 3-year CD. 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 3-year CD.
- Afraid of penalties? Consider a liquid CD! You can withdraw money without a penalty. Your interest rate will be lower for this privilege. Federal law mandates that CD money stay in the account for seven days prior to withdrawn 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 risk? 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. This way the bank reissue 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.
- Unfortunately, you are responsible for paying taxes on the phantom interest you earn.
There are a lot of choices in terms of how you want to buy a CD, and what type of CD buy. The best type of knowledge is the type you gain through experience. So, go ahead and buy a CD, and let me know how your experience was.