Certificates of Deposit offer higher yields and greater safety. Is that a good thing?
, by Rob Kaufman
Certificates of deposits (CDs) are investments, sold by banks that are typically bought with cash an investor won't need for a long period of time. Why? The money must remain invested for the full investment period (referred to as the "term" of the CD) in order for the bank to pay a slightly higher interest rate than what would have been earned if the money was kept in a money market or checking account. This is the "higher yield" feature of a CD.
A CD's "safety" feature is apparent by the fact that the interest rate is pre-determined (no potential of a decrease) and the CD holder is guaranteed the amount they invest - plus interest - once the CD reaches its maturity date. Plus, if the bank fails for any reason, the investment is most likely insured by the FDIC for up to $250,000.
It's for these two reasons (higher yields and increased safety) that many people opt for CDs. So why isn't everyone investing in CDs? What does one have to lose?
With lower risk investments come lower return. The interest rate you'll get on a CD is just a bit higher than that of a checking or savings account, so you won't be pulling in the big bucks when the CD matures. However, there are ways to help increase the return on CDs and that has to do with the type of CD you purchase.
Types of CDs
Want a little more interest than the traditional CD provides? You can see if your bank (or another financial institution) offers the following CD products...
Bump-Up CD allows you to exchange your CD's interest rate for a higher one if rates on new CDs of similar duration rise during your term.
Liquid CD lets you withdraw part of your deposit without paying a penalty. This type of CD typically offers an interest rate lower than other CDs, but still beats a money market or checking account rate.
Zero-coupon CD doesn't pay annual interest but reinvests the payments so you'll earn interest on a higher total deposit.
Callable CD means that the issuing bank can recall the CD after a set period of time, returning your deposit plus any interest owed. Banks often do this when interest rates fall below the rate initially offered. To help entice customer to purchase this type of CD, banks might pay a higher interest rate.
Is a Certificate of Deposit right for you?
CDs are usually part of a larger financial investment portfolio. It's important to look at your financial profile and determine short- and long-term investment objectives before making a commitment to purchasing a CD. Here are some facts that might help you with that strategy:
There's a large variety of CDs available from thousands of different banks and credit unions so you can find the one (or two... or three) that fits your needs.
CD holders can depend on a constant rate for the term of the CD.
The money in a CD is not easily accessible and a penalty is typically charged for early withdrawal.
CD rates usually lag behind rising inflation on the way up and drop more quickly than inflation on the way down. That could mean the investment will lose its purchasing power over time as interest gains are overtaken by inflation.
CDs can also be part of any emergency fund. See how at the myFICO blog titled: Money 911: Establishing an Emergency Fund.
To read more discussions and get a better perspective on CDs, visit the myFICO Forum.