Certificates Of Deposit: How They Work
Certificates of deposit (CDs) are relatively low-risk investments that pay a fixed interest rate on your money if you keep it in for a specified amount of time. It is a special type of deposit account with a bank or thrift institution that typically offers a higher interest rate than a regular savings account. Unlike other investments, CDs are generally insured by the FDIC up to the legal limit of US$250,000.
How CDs Work
When you buy a CD, you invest a fixed sum of money for fixed period of time – 6 months, 1 year, 2 years, 3 years, 4 years, 5 years, or more – and, in return, the issuing bank pays you interest, usually at regular intervals. Normally, the longer you keep your money in a CD, the more interest you’ll get. When you cash in or redeem your CD, you receive the money you originally invested plus any accrued interest.
But if you take your money out of the account before the specified amount of time has expired, you’ll be charged a penalty. The amount of the penalty varies, but it can be pretty hefty. Under some circumstances, you might even end up with less money than you started with if you pull out your money early.
You can purchase CDs through local banks and also through many brokerage firms. These brokerage firms, known as “deposit brokers”, can sometimes negotiate a higher interest rate for a CD by bringing in a certain volume of business to the bank. The deposit broker then in turn offers these “brokered CDs” to their customers.
In recent times, CDs have become much more varied. Most pay fixed rates, but some offer variable rates, meaning that the interest rate can change. The interest rates on CDs vary not only from bank to bank, they can change within a bank too. Rates are dependent on many factors, but they tend to follow closely the interest rates in the general market. Do watch out for CD specials from time to time.
Tip: If you buy CDs with low interest rates, purchase those that are short-term and wait for rates to rise. This prevents you from tying up your money for long periods of time!
Can The Issuing Bank Terminate A CD?
Yes, some long-term, high-yield CDs have “call” features, meaning that the issuing bank can choose to terminate – or call – the CD after only one year or some other specified period of time. For example, a bank might decide to call its high-yield CDs if interest rates decline. Only the issuing bank may call or terminate a CD, not the investor. But if you have invested in a long-term CD and interest rates subsequently rise, you’ll be locked in at the lower interest rate.
What Is An “Odd-Term” CD?
An odd-term CD has an unusual time period till maturity, for example, 5 months or 19 months, unlike the standard 6-month maturity.
What Is A “Step-Up” CD?
A step-up CD lets you lock in the current interest rate and take advantage of rising interest rates during the term of the CD, which usually ranges from one to five years, by converting to the higher rate without any penalty. You must notify the bank to initiate the step-up process. It does not automatically happen once the rates are changed.