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I began investing in certificates of deposit when I was 13. Back then (yes, we had color TV and telephones), there were just two options when it came to picking a CD: the term and the amount of money you wanted to invest. Today, things are a bit more complicated. The good news is that the many options available today can make these savings vehicles more attractive.
About Certificates of Deposit
Certificates of deposit (CDs) are a type of time deposit offered by FDIC-insured banks and NCUA-insured credit unions. They typically offer a higher interest rate than regular savings or money market accounts in exchange for keeping the funds deposited for a fixed period.
We’ll take a look at the types of CDs available today. As we do, keep two things in mind:
Early Withdrawal Penalties
With early withdrawal penalties, most CDs levy a penalty if you take your money out before the end of the term. Couple this with the fact that the longer the term, the higher the rates, and you find yourself weighing your desire for more interest with the likelihood you may need your money sooner than expected.
Fixed Interest Rates
Once you open a CD, you’re generally stuck with the interest rate for the entire term, even if prevailing rates are on the rise. Of course, this is a great feature when rates are falling.
I mention these two aspects of certificates of deposit because the variety of available options often gives investors a way to mitigate these risks.
There are several types of CDs, each with different features to meet varying investment goals and preferences. Most of the time I’ve chosen traditional CDs, although no-penalty CDs have been my investment of choice more recently. We’ll explore the differences below. Now let’s look at the types of CDs and how best to put them to use.
Types of CDs
The most common type of certificate of deposit, traditional CDs, offer a fixed interest rate over a specified term, usually ranging from 3 months up to 5 years or longer. Once the term ends, the CD matures, and the investor can withdraw the principal and earned interest. Early withdrawal penalties may apply if funds are withdrawn before the CD’s maturity date.
As with most CDs, deposits and withdrawals cannot be made to a traditional CD in the same way one makes similar transactions with a savings account. One must invest a lump sum when opening the CD. If a withdrawal is made, the entire balance of the CD must be withdrawn.
No-penalty CDs allow investors to withdraw their funds before the maturity date without incurring any penalties. They typically offer lower interest rates compared to traditional CDs to account for the added flexibility. At first glance, this may seem just like a savings account, but there are two significant differences.
First, unlike a savings account, if you want to take some of your money out of a no-penalty CD, you have to take all of it out. It’s all or nothing. Of course, you could turn around and open another one, but this quickly becomes a real chore. Second, the interest rate is fixed for the term of the CD, unlike a savings account, where rates can fluctuate daily.
A no-penalty CD is ideal for an emergency fund or anything else where you may need your money on short notice. We maintain a list of the best no-penalty CD rates that’s updated regularly. For my money, the CIT No-Penalty CD is one of the best offers currently available.
Bump Up CD
Also called a raise your rate CD, this option seeks to take the sting out of rising rates. Rather than sticking you with a rate for the entire term, if rates rise, you can choose to take advantage of the higher rate and “bump up” or increase your rate for the remainder of the term. But there’s a catch (there’s always a catch). You only can exercise this option once during the term of the CD. So choose wisely.
For example, suppose you buy a one-year CD at a given rate. If the bank’s customers are offered a quarter percent more on CDs six months into the term, a bump-up CD gives the consumer the option to tell the bank they want 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.
Bump-up CDs typically start with a lower initial interest rate compared to traditional CDs to account for the added flexibility. Ally Bank offers a bump-up CD, which it calls a “Raise Your Rate” CD.
Unlike a step-up CD (defined further below), where the bank automatically increases the rate periodically, with a bump-up CD, the investor decides when to take advantage of higher rates.
Brokered CDs are purchased through a brokerage firm rather than directly from a bank or credit union. With this type of CD, your broker pools your money with other investors and buys a large CD from a bank. Often, this allows you to work around penalty problems. If you want to cash out early, a broker can frequently sell your investment to another investor. This may still result in a small loss, depending on how interest rates have changed since you purchased the CD. If prevailing rates have risen since an investor purchased the CD, the current value of that brokered CD will have fallen. In this regard, the pricing of a brokered CD is very similar to that have a bond.
Brokerage CDs normally yield higher interest rates because 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.
Foreign Currency CD
These types of CDs are lots of fun. You invest in a certificate of deposit denominated in another currency. The CD can be specific to a single country or a basket of CDs from several countries. You get the potential for higher returns than what you can currently get in the U.S., and you also get some foreign currency exposure. Of course, with all this exposure comes risk. Don’t think of foreign currency CDs as safe, FDIC-insured accounts. They’re not. But they can make a nice addition to a well-diversified portfolio.
High Yield CD
These CDs offer a higher interest rate compared to traditional CDs. Although this is not an official definition, for me, a high yield CD is one that pays an interest rate in the top 5% of all FDIC-insured banks. This terminology can be a bit confusing because a high-yield CD is a type of traditional CD. In addition, there’s no official APY that a CD must offer to be deemed a high-yield CD.
Generally speaking, most of the higher-yielding CDs come from online-only banks. We maintain a list of the best current CD rates available, which includes these higher-paying options.
Callable CDs give the issuing bank the option to “call” or terminate the CD before its maturity date, typically after a specified call protection period. Normally, a bank will give you a premium rate when this predetermined period is in effect. At the end of the period, however, the bank is able to take back the premium rate and offer the consumer a lower, prevailing market rate.
Banks typically exercise this option if prevailing rates have fallen since the issuance of the CD. In this regard, a call feature of a CD protects the bank and the expense of the investor. If the bank exercises this option, investors receive their principal and any accrued interest.
Because the call feature favors the bank, callable CDs often offer higher interest rates to compensate for the risk of early termination. Generally, bank CDs are not callable. In my experience, brokered CDs are more likely to be callable.
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. These CDs usually yield a fixed interest rate for a predetermined period, for instance, one year, after which the rate is automatically increased or lowered to a predetermined rate. This structure can be advantageous for investors who anticipate rising interest rates and want to capitalize on those increases.
As an example, U.S. Bank offers a 28-month step-up CD. The interest rate automatically increases every seven months. Note that this particular CD offers a significantly lower APY than what is available from the best CD rates. As such, a step-up CD, while initially appealing, may not be a very good deal.
Add-on CDs allow investors to make additional deposits into the CD after the initial purchase, which is normally not permitted. You can see an example of an add-on CD from First Horizon Bank. As is often the case with CDs offering unique features, the yields on this type of CD are often far below the best rates available.
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 is reinvested together with the principal. At maturity, the investor receives the full face value of the CD, with the difference between the purchase price and the face value representing the interest earned. In this regard, zeros are similar to T-bills. Even if this type of CD is an option for an investor, one must remember that taxes must be paid even before receiving the actual interest.
A Jumbo CD requires a larger minimum deposit, typically $100,000 or more, 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.
In exchange for this higher investment, Jumbo CDs in theory offer higher interest rates compared to traditional CDs. In my experience, there is little difference between a traditional CD and a jumbo CD today. In fact, the highest-rate CDs available today often require a very small minimum deposit.
Consider a CD Ladder
If you want the higher rates of long term types of CDs but the ability to access your funds, consider using a CD ladder. Instead of buying one CD, you buy multiple CDs, each with different terms, so they will mature at different determined intervals.
Let’s say you have $20,000 to invest. You like the rates of a three-year CD but aren’t comfortable tying up all that money for that long. You could, for example, take out a CD for $4,000 every six months. In the initial investment period, you would always have liquid funds waiting to be invested in CDs. Three years after you took out your first CD, it would be maturing and soon be ready to reinvest. This way, if disaster strikes, you’ll always have a sum of money at most six months away from being available. And, if you need to withdraw early, you won’t pay penalties on your investment.
Whether you’re looking for a higher interest rate, the ability to access your funds without penalty, or a set rate that won’t fluctuate with the market, there’s a CD out there that’s right for you. Each has its own advantages and disadvantages, so it’s important to do your research and talk to your financial advisor about the different types of CDs.
Deciding which CD is right for you will depend on your individual needs and goals. Choosing a CD isn’t only about finding the one with the highest APY. Think about how much you have to deposit into the account, how long you want the term to be, and which one of these CD types best suits your needs.
Ready to take a look at the best CD rates available? We track hundreds of CD rates, including many of the types listed above. Rates are updated daily, but they also change often, so be sure to confirm rates with the bank or credit union’s website.