Offbeat Offerings: Certificates of Deposit
by Cara Scatizzi
A certificate of deposit (CD) is an interest-paying savings vehicle. A CD has a stated maturity date, a specified interest rate and can be issued in any denomination by commercial banks, thrifts and credit unions.
How It Works
A certificate of deposit is a promissory note issued by a bank, thrift institution or credit union. It is a time deposit, meaning the institution keeps your money for the stated time and you are restricted (in the form of a penalty) from accessing the money prior to the maturity date.
This type of investment is less liquid than a cash deposit such as a checking or money market account. Because of this, interest rates are usually higher compared to cash deposit rates. If you must access the money before maturity, you will pay a penalty (typically a loss of interest payment over a certain period), which will eat into your total return.
A typical CD can be purchased for any amount and has a number of time period options. The most popular are between three months and five years. Usually, a longer holding period means a higher interest rate. CDs are insured by the FDIC up to $100,000.
There are numerous types of CDs meeting most any investors holding period, interest rate and initial investment needs.
Traditional CDs, which most people are familiar with, allow you to deposit any amount of money, at a predetermined rate for a fixed time period. CDs with an initial investment of less than $100,000 are called small CDs. These are typically purchased by individual investors.
CDs with initial purchases of more than $100,000 are called jumbo CDs. These are usually purchased by institutional investors such as pension funds.
A bump-up CD gives you the option to increase the interest rate on your investment if the bank has increased the rate after you bought your CD. For example, if you bought a three-year CD at 5% and one year later the bank raises the rates on three-year CDs by 0.5%, you have the option to get the higher rate (5.5%) for the remainder of the term. Typically you have the option to do this only once during the holding period and the initial rate on the CD might be lower than a traditional CD rate to reflect this option. This can be a good option if you expect rates to rise substantially in the future.
A liquid CD allows investors to withdraw money without a penalty. Most banks will require a minimum balance over the life of the CD. Banks can also set a first penalty-free withdrawal date whenever they like, so you still may not be able to take out money right away. Also, there might be a limit to the number of withdrawals you can make over the CD term. The interest rate will typically be higher than a cash deposit account, but lower than a similar term traditional CD.
Zero-coupon CDs are very similar to zero-coupon bonds. You buy a CD at a deep discount to par, which is the amount you will receive at maturity. The coupon payments refer to the interest payments, so a zero-coupon CD will not earn interest. Your return depends on how much the initial investment is discounted from its par value.
Callable CDs allow a bank to call back a CD after the call-protection period expires, but before its maturity. In this case, the bank is attempting to shift interest rate risk to the investor. If rates fall, they can call any CDs with higher interest rates, and reissue them at the lower rate. There is typically an interest rate premium for investors purchasing this type of CD.
Brokerage CDs are sold through a brokerage firm. They often pay higher rates and are more liquid because the broker creates a secondary market. [For more detailed information about brokerage CDs, see the Offbeat Offerings column in the May 2007 AAII Journal.]
How to Trade
You can purchase a CD through any bank, thrift or credit union, and some brokerage firms. With the popularity of on-line banking, you have more options and more competitive rates. Your neighborhood bank may offer a rate that is more than it offers on a cash deposit, but typically an on-line bank can offer an even higher rate. This is because they do not have the costs associated with running brick-and-motor branches.
Investing in a CD at a bank or on-line is easy. After filling out the requisite paperwork, you can send the bank the money either via check or E-transfer from one bank to another. After the CD matures, the bank will typically transfer the money to a chosen account, or will roll it over into another CD.
Putting your cash reserve in a CD can earn you more interest than using a cash deposit account.
A more sophisticated way to invest in CDs is through laddering. Interest rates rise and fall as the economy ebbs and flows, and most investors do not want to get stuck in only low-interest-rate-paying CDs as rates are rising. One way around this dilemma is to ladder, spreading the maturity of your CDs over various timeframes. This technique assumes that longer-term CDs are almost always offered at a higher rate than shorter-term CDs.
As an example of a five-year ladder, with $20,000 to invest, you would invest $4,000 (or $20,000 ÷ 5) in each ladder rung, with the rungs consisting of one-, two-, three-, four-, and five-year CDs. After the one-year CD matures, it is rolled over into a new five-year CD (because after one year passes, each remaining CD has one year less until maturity). This will continue as long as you decide is appropriate.
By replacing the longest maturity CD each year, you will be getting a higher rate and if rates are rising, you will not be stuck in a long-term CD and unable to earn the higher rate.
For all CDs, you are taxed on any interest earned. Zero-coupon CDs are taxed on phantom income even though the actual interest is not paid to you. Your bank will send information about your interest earnings for tax purposes each year.
CDs are insured by the Federal Deposit Insurance Corp. (FDIC), for banks, and the National Credit Union Administration (NCUA), for credit unions. They are guaranteed to return the agreed upon rate over the CD term. [Make sure you understand the rules for FDIC and NCUA insurance coverage to ensure your CDs are fully covered.]
Higher Rate Than Cash Deposits
Because you do not have immediate access to the cash, banks typically offer a higher interest rate on CDs than on traditional cash deposits.
Most CDs do not have liquidity without penalty. If you withdraw the money before maturity, you will be heavily penalized.
Interest Rate Risk
Because you are locking in an interest rate, you may miss out on higher rates if interest rates rise. The longer the CD term, the higher the risk that your original rate will be lower than the going rate before it reaches maturity.
Compared to other riskier investments such as stocks, the returns can be very low.
BankRate.com offers a wealth of information on CDs. The CDs & Investments section includes frequently asked questions, national CD rate comparisons, recent news stories and commentaries about the CD market, calculators and more. All of the data is free and updated regularly.
The SEC offers tips on choosing and researching CDs.