Investing in Certificates of Deposit (CDs)
A Certificate of Deposit (CD) is a time deposit that entitles the holder to receive interest that is typically higher than traditional savings accounts. CDs pay these higher rates of interest because the holder of the CD agrees to a set term. Certificates of deposit are offered by most banks, credit unions and thrift institution and, like a savings account, provide insurance of the funds.
Investing in certificates of deposit differs from putting money into savings accounts because the investor agrees to a set term, which may range from three months to five years. Investors who do not expect to need the money for a known period of time might find CDs to be a good option. It’s worth noting, though, that if the investor chooses to take the money before the end of the term, they will pay a penalty.
Types of Certificates of Deposit
While the traditional certificate of deposit is the most popular choice, there are other CD options with differing features and flexibility that an investor might consider.
Traditional: Under the Traditional CD, the investor deposits the money for a specific interest rate and time period. At the end of the term, they have the option of cashing out the CD or continuing- rolling it over for another term. Early withdrawal penalties can lead to loss of interest and possibly a portion of the principal. The institution will disclose theses penalties at the time the account is opened.
Callable: Similar to a traditional CD, but the financial institution has the right to “call” (cash-out) the investment before the end of the term. The institution will offer a higher rate of interest to compensate for the callable feature.
Bump Up: Bump Up CDs offer the holder the opportunity for a one-time interest rate increase in case rates rise during the term. The option typically allows for only one increase during the term and has the drawback of usually offering a lower initial rate than a traditional CD.
Zero Coupon: Like zero coupon bonds, zero coupon CDs are sold at a deep discount and the holder receives the par value upon maturity, which may be up to 20 years. Zero coupon CDs make no payments to the holder until maturity.
Liquid: Liquid CDs are unique in that they offer the holder the opportunity to withdraw a portion of the principal without penalty, although there is generally a limit as to the number of withdrawals the holder can make and they total they may withdraw.
Brokerage: Brokerage CDs are sold through brokerage firms and trade like bonds on a secondary market. In addition to higher liquidity, these CDs often pay a higher rate of interest. These types of CDs often have call options attached to them.
Step Up or Step Down: Often called a “flex CD”, these instruments start with a fixed interest rate (usually for one year) and may be raised or lowered to a pre-determined rate after that.
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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