A CD, or certificate of deposit, is a type of savings tool that can offer a higher return on your money than most standard savings accounts. Better yet, there isn’t much risk involved, and CDs typically don’t have monthly fees. But before committing to a CD — and “commit” is the operative word, as you’ll see — you should know how they work and determine whether one will fit your needs.
WHAT IS A CERTIFICATE OF DEPOSIT (CD)?
A CD is different from a traditional savings account in several ways. A CD is what’s called a timed deposit. With a savings account you can deposit and withdraw funds relatively freely, but with a CD, you agree to keep your money there for a set period of time, called the term length. Term lengths can be as short as a few days or as long as a decade, but the standard range of options is between three months and five years.
The longer the term length — the longer you commit to keeping your money in the account and thus with the bank — the higher the interest rate you’ll earn.
SOME FEATURES OF CERTIFICATE OF DEPOSIT (CD)
TYPES OF CERTIFICATE OF DEPOSIT (CD)
1. Traditional CD
With a traditional CD, you deposit a fixed amount of money for a specific term and receive a predetermined interest rate. You have the option of cashing out at the end of the term, or rolling over the CD for another term. Most institutions don't allow you to add additional funds before your traditional CD matures.
Penalties for early withdrawal can be quite stiff and will cause you to lose interest, and possibly principal. Federal regulations set only the minimum early withdrawal penalty for traditional CDs. There is no law preventing an institution from enacting tougher penalties, but they must be disclosed when the account is opened. Before you pick a CD, it's important to calculate how much interest you could earn by the end of your term.
2. Bump-up CD
This type of CD allows you to take advantage of a rising-rate environment. Suppose you buy a 2-year CD at a given rate, and six months into the term the bank offers an additional quarter-point on the same investment. A bump-up CD gives you the option of telling the bank you want to get the higher rate for the remainder of the term. Institutions that offer this CD option usually allow only one bump-up per term.
The drawback is you may get a lower initial rate on a bump-up CD than on a traditional 2-year CD. The longer it takes interest rates to rise, the longer it will take to make up for the earlier, lower-rate portion of the term. Be sure you have realistic expectations about the interest-rate environment before buying a bump-up CD. See how bump-up CD deals stack up against traditional CD rates.
3. Liquid CD
These CDs offer consumers the opportunity to withdraw their money without incurring a penalty, although the depositor may have to maintain a minimum balance in the account. You can expect the interest rate on a liquid CD to be higher than the bank's money market rate. But it's usually lower than the rate on a traditional CD of the same term. You'll have to weigh the convenience of liquidity against whatever return you're sacrificing.
A key consideration when purchasing a liquid CD is how soon you can make a withdrawal after opening the account. Federal law requires that the money stay in the account for seven days before it can be withdrawn without penalty, but banks can set the first penalty-free withdrawal for any time beyond that.
4. Zero-coupon CD
These CDs are similar to zero-coupon bonds. As with the bond, you buy the CD at a deep discount to its par value (or the amount you'll receive when the CD matures). "Coupon" refers to a periodic interest payment. Zero-coupon means there are no interest payments. So, you might buy a 12-year, 84,890 € CD for 42,445 €, and you wouldn't receive any interest payments over the course of the term. You'd receive the 84,890 € face value when the CD matures.
One drawback is that zero-coupon CDs are usually long-term investments, and you take on considerable interest-rate risk. If interest rates rise during the 10-year term in question, you'll be on the losing end of that deal. Another potential problem is that you're credited with phantom income each year. No money is being put in your pocket, but you'll have to pay Uncle Sam on the earnings being accrued. In our example, you'd earn 2,546.7 € during the first year and would owe tax on the money, though you haven't actually received it. Each year, you'll have a higher base than the year before -- and a bigger tax bill. Make sure you have room in your budget to cover the taxes.
5. Callable CD
With a callable CD, the bank that issues the CD can "call" it away from you after your call-protection period expires, and before the CD matures. For instance, if you buy a 5-year CD with a six-month call-protection period, it would be callable after the first six months. Just as with the zero-coupon CD, the bank is shifting interest-rate risk on to your shoulders. If it issues the CD at 3 percent and six months later rates drop, the bank is now paying 2 percent on 5-year CDs.
The bank can call, or take back, your CD and reissue it at 2 percent. You'll receive your full principal and interest earned. But you're stuck reinvesting your money at lower rates. Usually, banks pay a premium for taking on the risk that the CD may be called. They may pay investors a quarter- or half-percent more on a callable CD than they would on a CD without the call feature. Compare CD rates now to land the best deal.
6. Brokered CD
A brokered CD is simply a certificate of deposit sold through a brokerage firm. To qualify for one, you'll need a brokerage account. Some banks use brokers as sales representatives to find investors willing to purchase the banks' CDs. Buying CDs through a brokerage can be convenient. There's no need to open accounts at a variety of banks just to get the best CD yields. Brokered CDs often pay higher rates than CDs from your local bank because banks using brokered CDs compete in a national marketplace.
Brokered CDs are more liquid than bank CDs because they can be traded like bonds on the secondary market. But there is no guarantee you won't take a loss. The only way to guarantee getting your full principal and interest is to hold the CD until maturity. Don't assume all brokered CDs are backed by the Federal Deposit Insurance Corp. It's up to you to do your due diligence and look for that on the broker's website. You should also watch out for brokered CDs that have call options.
7. High-yield CD
Banks compete for deposits by offering better-than-average rates, and Bankrate offers the best route for finding the highest rates in the nation.
Bank rate surveys local and national institutions to find banks offering the highest yields on CDs. All accounts are directly offered to the consumer by the institution but take time to compare the best CD rates then calculate your potential earnings.
CRITICISM
CD interest rates closely track inflation. For example, in one situation interest rates may be 15% and inflation may be 15%, and in another situation interest rates may be 2% and inflation may be 2%. Of course, these factors cancel out, so the real interest rate is the same in both cases.
In this situation, it is a misinterpretation that the interest is an increase in value. However, to keep the same value, the rate of withdrawal must be the same as the real rate of return, in this case, zero. People may also think that the higher-rate situation is "better", when the real rate of return is actually the same. Also, the above does not include taxes. When taxes are considered, the higher-rate situation above is worse, with a lower (more negative) real return, although the before-tax real rates of return are identical. The after-inflation, after-tax return is what's important. You don't make any money in bank accounts (in real economic terms), simply because you're not supposed to. On the other hand, bank accounts and CDs are fine for holding cash for a short amount of time.
Even if CD rates track inflation, this can only be the expected inflation at the time the CD is bought. The actual inflation will be lower or higher. Locking in the interest rate for a long term may be bad (if inflation goes up) or good (if inflation goes down). For example, in the 1970s, inflation increased higher than it had been, and banks were slow to raise their interest rates. This does not much affect a person with a short note, since they get their money back, and they can go somewhere else (or the same place) that gives a higher rate. But longer notes are locked in their rate. This gave rise to amusing nicknames for CDs. A bit later, the opposite happened, where inflation was declining. This does not greatly help a person with a short note, since they shortly get their money back and they are forced to reinvest at a new, lower rate. But longer notes become very valuable since they have a higher interest rate.
However, this applies only to "average" CD interest rates. In reality, some banks pay much lower than average rates, while others pay much higher rates (two-fold differences are not unusual, e.g., 2.5% vs 5%). In the United States, depositors can take advantage of the best FDIC-insured rates without increasing their risk.
Investors should be suspicious of an unusually high interest rate on a CD. Allen Stanford used fraudulent CDs with high rates to lure people into his Ponzi scheme.
Finally, the statement that "CD interest rates closely track inflation" is not necessarily true. For example, during a credit crunch banks are in dire need of funds, and CD interest rate increases may not track inflation.
TERMS AND CONDITIONS FOR CERTIFICATE OF DEPOSIT
There are many variations in the terms and conditions for CDs.
The federally required "Truth in Savings" booklet, or other disclosure document that gives the terms of the CD, must be made available before the purchase. Employees of the institution are generally not familiar with this information[citation needed]; only the written document carries legal weight. If the original issuing institution has merged with another institution, or if the CD is closed early by the purchaser, or there is some other issue, the purchaser will need to refer to the terms and conditions document to ensure that the withdrawal is processed following the original terms of the contract.
CD RATES
As a reward for parking your cash with them for a longer time, banks and credit unions often offer higher CD rates than their savings account rates. CD rates are quoted as an annual percentage yield, or APY, which considers the frequency with which interest is paid on the account (aka the compounding period). Banks can choose to compound rates on a yearly, quarterly, monthly or even daily basis.
The average rate on a three-year CD at a bank currently stands at 0.50%. However, many credit unions and online-only banks offer certificates with rates above 1%.
CERTIFICATE OF DEPOSIT (CD) EARLY WITHDRAWAL PENALTIES
If you end your commitment early by withdrawing the money before the CD matures, you’ll likely be charged a penalty. It varies, but typically you’ll give up three to six months’ worth of interest accrued. Consumers should take note of any such penalty on a CD before choosing to withdraw early. The loss of interest may outweigh the benefits of taking the money out.
INSURANCE
CDs at most banks are backed by the Federal Deposit Insurance Corp., or FDIC, for up to 212,225 €. At credit unions, share certificates are insured up to the same amount through the National Credit Union Administration, or NCUA. Some state-chartered credit unions may operate with private insurance. This insurance does not cover penalties incurred by withdrawing funds early.
How can you tell if your bank or credit union offers insurance? All institutions with federal backing must display FDIC or NCUA signs at teller windows and on their websites. If they do, coverage is automatic. You don’t have to apply for your money to be insured.
WHAT IS A CERTIFICATE OF DEPOSIT (CD)?
A CD is different from a traditional savings account in several ways. A CD is what’s called a timed deposit. With a savings account you can deposit and withdraw funds relatively freely, but with a CD, you agree to keep your money there for a set period of time, called the term length. Term lengths can be as short as a few days or as long as a decade, but the standard range of options is between three months and five years.
The longer the term length — the longer you commit to keeping your money in the account and thus with the bank — the higher the interest rate you’ll earn.
SOME FEATURES OF CERTIFICATE OF DEPOSIT (CD)
- A larger principal should/may receive a higher interest rate.
- A longer term usually earns a higher interest rate, except in the case of an inverted yield curve (e.g., preceding a recession).
- Smaller institutions tend to offer higher interest rates than larger ones.
- Personal CD accounts generally receive higher interest rates than business CD accounts.
- Banks and credit unions that are not insured by the FDIC or NCUA generally offer higher interest rates.
TYPES OF CERTIFICATE OF DEPOSIT (CD)
- Traditional CD
- Bump-up CD
- Liquid CD
- Zero-coupon CD
- Callable CD
- Brokered CD
- High-yield CD
1. Traditional CD
With a traditional CD, you deposit a fixed amount of money for a specific term and receive a predetermined interest rate. You have the option of cashing out at the end of the term, or rolling over the CD for another term. Most institutions don't allow you to add additional funds before your traditional CD matures.
Penalties for early withdrawal can be quite stiff and will cause you to lose interest, and possibly principal. Federal regulations set only the minimum early withdrawal penalty for traditional CDs. There is no law preventing an institution from enacting tougher penalties, but they must be disclosed when the account is opened. Before you pick a CD, it's important to calculate how much interest you could earn by the end of your term.
2. Bump-up CD
This type of CD allows you to take advantage of a rising-rate environment. Suppose you buy a 2-year CD at a given rate, and six months into the term the bank offers an additional quarter-point on the same investment. A bump-up CD gives you the option of telling the bank you want to get the higher rate for the remainder of the term. Institutions that offer this CD option usually allow only one bump-up per term.
The drawback is you may get a lower initial rate on a bump-up CD than on a traditional 2-year CD. The longer it takes interest rates to rise, the longer it will take to make up for the earlier, lower-rate portion of the term. Be sure you have realistic expectations about the interest-rate environment before buying a bump-up CD. See how bump-up CD deals stack up against traditional CD rates.
3. Liquid CD
These CDs offer consumers the opportunity to withdraw their money without incurring a penalty, although the depositor may have to maintain a minimum balance in the account. You can expect the interest rate on a liquid CD to be higher than the bank's money market rate. But it's usually lower than the rate on a traditional CD of the same term. You'll have to weigh the convenience of liquidity against whatever return you're sacrificing.
A key consideration when purchasing a liquid CD is how soon you can make a withdrawal after opening the account. Federal law requires that the money stay in the account for seven days before it can be withdrawn without penalty, but banks can set the first penalty-free withdrawal for any time beyond that.
4. Zero-coupon CD
These CDs are similar to zero-coupon bonds. As with the bond, you buy the CD at a deep discount to its par value (or the amount you'll receive when the CD matures). "Coupon" refers to a periodic interest payment. Zero-coupon means there are no interest payments. So, you might buy a 12-year, 84,890 € CD for 42,445 €, and you wouldn't receive any interest payments over the course of the term. You'd receive the 84,890 € face value when the CD matures.
One drawback is that zero-coupon CDs are usually long-term investments, and you take on considerable interest-rate risk. If interest rates rise during the 10-year term in question, you'll be on the losing end of that deal. Another potential problem is that you're credited with phantom income each year. No money is being put in your pocket, but you'll have to pay Uncle Sam on the earnings being accrued. In our example, you'd earn 2,546.7 € during the first year and would owe tax on the money, though you haven't actually received it. Each year, you'll have a higher base than the year before -- and a bigger tax bill. Make sure you have room in your budget to cover the taxes.
5. Callable CD
With a callable CD, the bank that issues the CD can "call" it away from you after your call-protection period expires, and before the CD matures. For instance, if you buy a 5-year CD with a six-month call-protection period, it would be callable after the first six months. Just as with the zero-coupon CD, the bank is shifting interest-rate risk on to your shoulders. If it issues the CD at 3 percent and six months later rates drop, the bank is now paying 2 percent on 5-year CDs.
The bank can call, or take back, your CD and reissue it at 2 percent. You'll receive your full principal and interest earned. But you're stuck reinvesting your money at lower rates. Usually, banks pay a premium for taking on the risk that the CD may be called. They may pay investors a quarter- or half-percent more on a callable CD than they would on a CD without the call feature. Compare CD rates now to land the best deal.
6. Brokered CD
A brokered CD is simply a certificate of deposit sold through a brokerage firm. To qualify for one, you'll need a brokerage account. Some banks use brokers as sales representatives to find investors willing to purchase the banks' CDs. Buying CDs through a brokerage can be convenient. There's no need to open accounts at a variety of banks just to get the best CD yields. Brokered CDs often pay higher rates than CDs from your local bank because banks using brokered CDs compete in a national marketplace.
Brokered CDs are more liquid than bank CDs because they can be traded like bonds on the secondary market. But there is no guarantee you won't take a loss. The only way to guarantee getting your full principal and interest is to hold the CD until maturity. Don't assume all brokered CDs are backed by the Federal Deposit Insurance Corp. It's up to you to do your due diligence and look for that on the broker's website. You should also watch out for brokered CDs that have call options.
7. High-yield CD
Banks compete for deposits by offering better-than-average rates, and Bankrate offers the best route for finding the highest rates in the nation.
Bank rate surveys local and national institutions to find banks offering the highest yields on CDs. All accounts are directly offered to the consumer by the institution but take time to compare the best CD rates then calculate your potential earnings.
CRITICISM
CD interest rates closely track inflation. For example, in one situation interest rates may be 15% and inflation may be 15%, and in another situation interest rates may be 2% and inflation may be 2%. Of course, these factors cancel out, so the real interest rate is the same in both cases.
In this situation, it is a misinterpretation that the interest is an increase in value. However, to keep the same value, the rate of withdrawal must be the same as the real rate of return, in this case, zero. People may also think that the higher-rate situation is "better", when the real rate of return is actually the same. Also, the above does not include taxes. When taxes are considered, the higher-rate situation above is worse, with a lower (more negative) real return, although the before-tax real rates of return are identical. The after-inflation, after-tax return is what's important. You don't make any money in bank accounts (in real economic terms), simply because you're not supposed to. On the other hand, bank accounts and CDs are fine for holding cash for a short amount of time.
Even if CD rates track inflation, this can only be the expected inflation at the time the CD is bought. The actual inflation will be lower or higher. Locking in the interest rate for a long term may be bad (if inflation goes up) or good (if inflation goes down). For example, in the 1970s, inflation increased higher than it had been, and banks were slow to raise their interest rates. This does not much affect a person with a short note, since they get their money back, and they can go somewhere else (or the same place) that gives a higher rate. But longer notes are locked in their rate. This gave rise to amusing nicknames for CDs. A bit later, the opposite happened, where inflation was declining. This does not greatly help a person with a short note, since they shortly get their money back and they are forced to reinvest at a new, lower rate. But longer notes become very valuable since they have a higher interest rate.
However, this applies only to "average" CD interest rates. In reality, some banks pay much lower than average rates, while others pay much higher rates (two-fold differences are not unusual, e.g., 2.5% vs 5%). In the United States, depositors can take advantage of the best FDIC-insured rates without increasing their risk.
Investors should be suspicious of an unusually high interest rate on a CD. Allen Stanford used fraudulent CDs with high rates to lure people into his Ponzi scheme.
Finally, the statement that "CD interest rates closely track inflation" is not necessarily true. For example, during a credit crunch banks are in dire need of funds, and CD interest rate increases may not track inflation.
TERMS AND CONDITIONS FOR CERTIFICATE OF DEPOSIT
There are many variations in the terms and conditions for CDs.
The federally required "Truth in Savings" booklet, or other disclosure document that gives the terms of the CD, must be made available before the purchase. Employees of the institution are generally not familiar with this information[citation needed]; only the written document carries legal weight. If the original issuing institution has merged with another institution, or if the CD is closed early by the purchaser, or there is some other issue, the purchaser will need to refer to the terms and conditions document to ensure that the withdrawal is processed following the original terms of the contract.
- The terms and conditions may be changeable. They may contain language such as "We can add to, delete or make any other changes ("Changes") we want to these Terms at any time."
- The CD may be callable. The terms may state that the bank or credit union can close the CD before the term ends.
- Payment of interest. Interest may be paid out as it is accrued or it may accumulate in the CD.
- Interest calculation. The CD may start earning interest from the date of deposit or from the start of the next month or quarter.
- Right to delay withdrawals. Institutions generally have the right to delay withdrawals for a specified period to stop a bank run.
- Withdrawal of principal. May be at the discretion of the financial institution. Withdrawal of principal below a certain minimum—or any withdrawal of principal at all—may require closure of the entire CD. A US Individual Retirement Account CD may allow withdrawal of IRA Required Minimum Distributions without a withdrawal penalty.
- Withdrawal of interest. May be limited to the most recent interest payment or allow for withdrawal of accumulated total interest since the CD was opened. Interest may be calculated to date of withdrawal or through the end of the last month or last quarter.
- Penalty for early withdrawal. May be measured in months of interest, may be calculated to be equal to the institution's current cost of replacing the money, or may use another formula. May or may not reduce the principal—for example, if principal is withdrawn three months after opening a CD with a six-month penalty.
- Fees. A fee may be specified for withdrawal or closure or for providing a certified check.
- Automatic renewal. The institution may or may not commit to sending a notice before automatic rollover at CD maturity. The institution may specify a grace period before automatically rolling over the CD to a new CD at maturity. Some banks have been known to renew at rates lower than that of the original CD.
CD RATES
As a reward for parking your cash with them for a longer time, banks and credit unions often offer higher CD rates than their savings account rates. CD rates are quoted as an annual percentage yield, or APY, which considers the frequency with which interest is paid on the account (aka the compounding period). Banks can choose to compound rates on a yearly, quarterly, monthly or even daily basis.
The average rate on a three-year CD at a bank currently stands at 0.50%. However, many credit unions and online-only banks offer certificates with rates above 1%.
CERTIFICATE OF DEPOSIT (CD) EARLY WITHDRAWAL PENALTIES
If you end your commitment early by withdrawing the money before the CD matures, you’ll likely be charged a penalty. It varies, but typically you’ll give up three to six months’ worth of interest accrued. Consumers should take note of any such penalty on a CD before choosing to withdraw early. The loss of interest may outweigh the benefits of taking the money out.
INSURANCE
CDs at most banks are backed by the Federal Deposit Insurance Corp., or FDIC, for up to 212,225 €. At credit unions, share certificates are insured up to the same amount through the National Credit Union Administration, or NCUA. Some state-chartered credit unions may operate with private insurance. This insurance does not cover penalties incurred by withdrawing funds early.
How can you tell if your bank or credit union offers insurance? All institutions with federal backing must display FDIC or NCUA signs at teller windows and on their websites. If they do, coverage is automatic. You don’t have to apply for your money to be insured.