Certificates of Deposit, otherwise known as CDs, commonly offered by banks, thrift institutions and credit unions are used by consumers who have no immediate plans for their cash yet want to benefit from a higher yield for their money than other FDIC-backed investment vehicles would offer. As a result of its FDIC status, CDs are virtually risk free; they have a specific, fixed term (often three months, six months, or one to five years). In exchange for keeping money in the bank for a specified period of time versus a savings account in which the consumer can withdraw money “on demand,” CDs normally offer a higher rate of interest. Fixed interest rates generally tend to be the norm, however, some banking institutions offer CDs with various forms of variable rates.
For the most part, CDs are a “plain vanilla” financial product, but there are some non-traditional CD options which offer the investor alternatives. These include the following:
Callable – A Callable CD is one that a bank has the ability to “call away” after a predetermined holding period has expired. Normally, a bank will give you a premium rate during the time that this predetermined period is in effect, yet at the end of the period, the bank is able to take back the premium rate and offer the consumer a lower, prevailing market rate. This works to the bank’s advantage in that if interest rates go down, the bank will likely exercise its option to call the CD after the holding period.
Bump Up – A Bump Up CD gives the depositor the chance to “bump up” or opt for a higher interest rate should CD rates increase over the life of the CD. However, this can only be done once during the CD’s term of duration. For example, suppose you buy a one-year CD at a given rate. If six months into the term the bank’s customers are offered a quarter percent more on CDs, a bump-up CD gives the consumer the option to tell the bank he/she wants to get the higher rate for the remainder of the term. By purchasing a bump-up CD, the consumer is taking the chance that rates will increase. The yield on bump up CDs is slightly lower than the yield on a CD with an equivalent duration without the bump-up option.
Liquid – Unlike conventional CDs for which the consumer usually faces a penalty if money is withdrawn before the term expires, liquid CDs allow the depositor to withdraw without being charged a penalty. However, to have this option the minimum amount needed to open and maintain this type of CD is much higher than the usual balance required; interest rates for liquid CDs are lower than traditional CD rates; and financial institutions usually establish a maximum number of times you can withdraw within the term of the CD.
Step Up or Step Down – A step up or step down CD is also known as a Flex CD. The Step Up or Step Down CD usually yields a fixed interest rate for a predetermined period of time, for instance, one year, after which the rate is automatically increased or lowered to a predetermined rate.
Brokerage – Brokerage CDs are purchased by investors through a broker instead of a banking institution. Brokerage CDs normally yield higher interest rates because the brokerage firms can pool investments before buying a bank’s CDs. Brokerage CDs are traded on the secondary market and are very liquid; consumers can withdraw funds without facing a penalty, however the risk of losing principal is also present because of exposure to market volatility. Additionally, some brokerage CDs are not FDIC insured.
Zero-Coupon – Zero-coupon CDs work in the same fashion as zero coupon bonds: the CDs are purchased at a large discount to their face value and make no interest payments over the life of the CD. During the life of the CD, interest will be reinvested together with the principal. Even if this type of CD is an option for an investor, one has to remember that taxes must be paid even before receiving the actual interest.
Jumbo – A jumbo CD is sold in a large denomination, usually a minimum of $100,000 and is normally purchased by large institutional investors such as banks or pension funds. Jumbo CDs are also known as negotiable certificates of deposits and come in bearer form.
With all of the above to choose from, there is certainly a CD out there to fit investor’s needs and time horizon.