A certificate of deposit, also known as a CD, is an account that has a fixed-term limit on it. When you deposit your money into a CD, you must wait for the term to be over before you can access the cash. While you are waiting to be able to withdraw money from the account, it gains interest. Most CDs typically have a high annual percentage yield (APY), so your investment will usually grow a decent amount before you have access to it. There are actually many types of CDs and knowing their differences is important to find the best one for your needs.
For a traditional CD, you deposit a certain amount of money, are given a specific term time, and earn a set percentage on the money in the account. With this type of CD, at the end of your term, you have the option to either cash out the account or rollover to another term and earn even more interest. Banks will usually allow you to deposit more money in the account before the term is up or when it is rolling over. If you choose to withdraw cash early, however, there are usually very high penalty fees. Federally, there is no regulation for what the maximum penalty can be, but they do set a minimum. The terms and fees an institute has should be disclosed when you are opening the account.
A bump-up CD lets you utilize rising interest rates. In a bump-up CD, you will be given a set interest rate and a set term. During that term, however, if the bank offers a higher interest rate, you have the option of telling the bank you would like to receive that rate for the rest of your term. Typically, these types of CDs offer only one bump-up per term, so make sure you use it wisely. On these accounts, the initial interest rate may be lower than a traditional CD. If the interest rate takes a while to rise, you will have to accept the lower interest rate that was given to you until it does. When purchasing a bump-up CD, keep in mind that this will likely be the case.
A liquid CD offers withdrawing cash from the account without facing any of the penalty fees. To maintain this privilege, you usually must keep a minimum balance on the account. A liquid CD traditionally will have a lower interest rate than a traditional CD, but it will still be higher than a money market account or a savings account. Federally, money placed into a CD must be left alone for 7 days before it can be taken out. Each individual bank can have a term higher than that, however. Banks also may put a limit on how many withdrawals can be made on the account. When considering a liquid CD, you should keep in mind how often you would take money from it and if it is worth the loss of interest earnings.
You might have heard of a zero-coupon bond, but not a zero-coupon CD. Zero-coupon means no interest payments, so your CD will not receive any interest on the account. You still will receive the face value of you CD when the term is over. If you buy a five year, $20,000 zero-coupon CD with a 4% interest rate for $8,000, you will not receive any interest on your initial investment ($8,000), but will receive the $20,000 when the term is over.
Since zero-coupon CDs typically are long-term investments, the lack of interest can be risky. A large rise in interest rates during your term could lead to a loss of yield. Another pitfall of a zero-coupon CD is that you still must pay taxes on the interest, even though you haven’t received any. When considering purchasing a zero-coupon CD, you should make sure that you have the money to offset the tax costs.
With a callable CD, the bank you got the CD from can “call” it away from you after the protection period is over, but before the CD reaches maturity. A six year CD with a call protection period of 8 months will be eligible to be called after the first 8 months. “Calling” refers to decreasing the interest rate on the account. As a bank’s interest rates fluctuate, a callable CD has the possibility of having its interest rate lowered. If the bank drops interest rates on six year CDs, they could possibly call the one that you purchased and you will now have the lower interest rate. You will still receive the initial face value and all the interest you have earned until that point. Banks will typically give an investor a cash incentive to take this type of CD or a higher interest rate than a traditional CD.
A brokerage CD is simply sold through a broker rather than a bank. These brokers typically still do work for a bank, however, and are paid to find investors to purchase that bank’s CDs. To purchase this type of CD, you must have an account with the broker. This is convenient for most people since they are already using the broker they purchase the CD from.
Instead of opening multiple accounts at many different banks to get high yields, you can do it all through the same place and person. A brokered CD typically will have higher rates than a CD purchased at a bank since the banks that provide brokered CDs are competing at a national level. Brokered CDs can be traded, like a bond, in a secondary market, so they are a bit more flexible than a traditional CD purchased from a bank. Brokered CDs often will have a callable option as well. There is a large possibility that your brokered CD could be backed by the FDIC, so make sure you look for those terms in writing when you are buying it.
Chose the Right Investment for You
Investing in a CD is a great idea. There are many different types that allow investors to have options. Whether you are looking for a more traditional approach or a CD with a bit more flexibility, there is an option out there. Finding the best rates can be made simple by using a broker and purchasing a brokered CD. Keeping your mind open to all the options will get you the best bang for your buck.