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.
About Certificates of Deposit
Today, things are a bit more complicated. The good news is that the many options available today can make these savings vehicles more attractive. We’ll take a look at the types of CDs available today. As we do, keep two things in mind:
1. 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.
2. 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 options now available often give investors a way to mitigate these risks.
So now let’s look at the types of CDs and how best to put them to use.
Types of CDs
No Penalty CD: As the name suggest, some certificates of deposit will not levy a penalty if you take your money out earlier. 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 is updated regularly. For my money, the Ally Bank 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 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 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.
Brokered CD: In this situation, 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.
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.
Foreign Currency CD: These 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 it can be 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 are not. But they can make a nice addition to a well diversified portfolio.
High Yield CD: 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. Much of the time this limits your options to online banks. We maintain a list of the best current CD rates available, which includes these higher paying options.
Callable: A Callable CD is one that a bank can “call away” after a predetermined holding period. Normally, a bank will give you a premium rate during the time that 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.
This works to the bank’s advantage. If interest rates go down, the bank will likely exercise its option to call the CD after the holding period.
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.
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.
Finally, if you want the higher rates of long term 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 that 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 all of your investment.