A certificate of deposit is the safest investment a person can make. This WealthHow article will enlighten you about the main 4 types of certificates of deposit.
A certificate of deposit, abbreviated as CD, is sold by banks to their customers. It is a type of deposit account, or rather, a type of low-risk investment, which pays a relatively higher interest than a regular savings account. Let us assume you have a certain amount of cash which you do not wish to spend but rather invest in a low-risk option, then a CD is the perfect option for investing the same. If the amount is not withdrawn during the stipulated duration or term, then the bank offers you a slightly higher rate of interest than a checking account. Thus, this a good option to safely deposit your earnings or cash for a short while. Now, there are different types of certificates of deposit, and the 4 main ones are elaborated in the paragraphs below.
- First and foremost, keep in mind that CDs are protected under the Federal Deposit Insurance Corporation (FDIC). Therefore, your money is just as safe as it would be with other accounts.
- CDs earn compound interest. And, when you open such an account, you have to deposit a sum for a particular time period, known as ‘term’. This ranges from 6 to 12 months and so on, up to 60 months. Generally, it is said that you’ll earn much more with longer terms, but it need not always be the best option.
- When you open a CD with a bank, you have to specify the term first. Then, you need to deposit a minimum amount. If you deposit a larger amount, you may get a higher rate of interest. After verifying and filling your details, you will receive a certificate. However, nowadays, there is no such concept. The deposit is mentioned in your bank statements. If you need a hard copy, you may have to apply for it separately at the bank.
- These CDs have maturity dates too. When a CD matures, i.e., the specified term ends, generally, you receive a notification from the bank. At this juncture, based on your choice, you can reinvest the amount in another CD, transfer the amount in your savings account, or withdraw all the cash.
- During the entire term, your cash is just sitting in the bank, plain and safe, and interest is being accumulated on the deposited amount. However, remember that, if you withdraw the money earlier than the term, you will have to pay a penalty. More on this a little later, but now, let’s take a look at the major types of CDs.
It is one of the most common types where you can deposit a certain amount of money for a particular period with a specific rate of interest (determined earlier). After your term expires, if you want, your money will be reinvested in another CD or you can withdraw the amount. While reinvesting, you can increase the amount to be deposited. The rate of interest is generally not variable, and can be compounded from an everyday basis to an annual basis. An important point to remember here is that, if you withdraw your cash earlier than the maturity date, the penalties incurred can be very stiff and severe. You run the risk of losing your interest, and in some cases, you may lose the principal amount as well.
Sometimes, people are apprehensive at the thought of depositing money and letting it lie idle. And this fear is well reasoned, because people might need cash during the specified term – to pay bills, fees, or an emergency. In such cases, one can opt for a liquid certificate. It gives you the advantage of not having to pay any penalty in case of an early withdrawal. A point to remember here that, for early withdrawal, you need to maintain a minimum amount in your account, you can’t just withdraw all the deposited amount at your convenience. For the record, you can withdraw the amount only after a week of depositing it. A liquid CD offers a slightly lower rate of interest for the same amount and term as compared to its traditional counterpart; however, the interest rate is still better than what is offered for a money market account.
The general disadvantage associated with CDs is that your cash is locked away with a predetermined interest rate, which means that if the rates increase during the term or period of holding, you will not receive any benefit. So, even if the interest rates increase, your cash will be valued at the rate decided at the beginning of the term. In such scenarios, you can use the bump-up option. Here, you benefit from the rising interest rates. For instance, if you have deposited USD 45,000 for a period of 2 years at 5%, and if at the end of one year, the interest rate rises to 8%, your money for the remaining term will be compounded at 8%. However, this is generally permitted only once during the entire term, you are not liable to benefit in case the interest rates keep rising. Also, since you have this advantage, your rate of interest at the beginning of the term will be lower.
In a brokerage type of deposit, one deposits the desired amount to a broker or a brokerage firm rather than a bank. They generally offer very high rates of interest, since they compete on a national basis and have access to a large number of banks. However, this option is said to be quite complicated and risky. This is because you are actually going to place your trust and your cash with an individual (even if he has a good reputation, he may not be reliable or trustworthy) and not a financial institution, you need to keep track of how the cash is being invested, as well as the record-keeping policies. Also, since a broker will be doing the work for you, you will have to pay him for his services.
This CD is termed so, since it can be ‘called’, meaning, it can be terminated by the bank before its maturity period. Generally, this ‘call’ is taken by the bank when the interest rates fall. In such a scenario, in case of a callable CD, the bank terminates the CD and gives you the principal amount and the accrued interest up to that point. In most cases, getting ‘called’ simply means that the bank reissues the amount at a lower interest rate. Therefore, initially, this CD offers a high rate of interest. Remember that it is mostly done through brokerage firms. Also, banks generally pay you a premium with this kind of CD.
As the name suggests, when financial institutions offer a very high rate of interest to compete with their peers in the market, it is called high-yield. In return, they mostly require you to deposit a high initial principal amount. This can be a high risk option, since the high interest is more of a lure, a business strategy to attract clients and compete with other banks and credit unions. According to some investors, these offers may be limited to customers who open a new account, and may or may not last throughout the term. Or, the specifics of the CD regarding withdrawal penalties, period before withdrawal, term, etc., may not be clearly penned down. Remember that this CD does not have any benchmark; to be more precise, it does not depend on any market index. Therefore, according to the Federal Deposit Insurance Corporation (FDIC), this is a complicated and risky option.
These deposits are sold by banks at a discount, i.e., it does not pay out the annual interest, instead, your payments are reinvested so that you get a higher deposit. This option also offers a higher interest rate. The disadvantage here is that you’ll have to pay taxes on the reinvested amount.
It is pretty similar to the bump-up option. However, with this option, a person can benefit from the raised rate of interest, more than once, though there is a defined duration during which a person cannot raise the rates.
Here, the rate of interest is not predetermined or fixed, but is based on the market value. This means, that you benefit if the overall interest rate increase in the future. However, you also have to bear the brunt of a lower interest rates, i.e., when the market interest rate sinks, your account will be affected too. Thus, it does not offer you any extra advantages or security.
In this option, a person can add more cash to the already existing principal amount, i.e., during the term, you are allowed to make a limited number of cash deposits to the initial amount. However, like the traditional CD, your rate of interest is locked for the entire term. Also, your money could be forfeited if you withdraw the cash earlier than the stipulated period.
This is the interest rate that a bank is offering on a CD. The term is also used while availing a loan.
This is simply a tool to check how much your account will earn over its specified term. It will tell you how much money you are making.
Before deciding which type of CD is best for you, consider the following factors.
Before investing, make a financial plan. Make a note what your goals and ambitions are, and then write down how you plan to invest your savings so that you get successful returns. Consult financial advisers and agents, and take their advice and opinions. You need to consider a number of factors, like recession, current market scenario, investment schemes, insurance policies, money market funds, deposit accounts, treasury bills, etc.
This is an important point to be thought over. Generally, you will have a fixed rate of interest. But, from the types above, we can see that it changes according to which deposit you choose, as well as the market situation. Make sure to ask the bank the correct rate of interest according to the type, and if possible, put it down on paper. Confirm this fact twice/thrice, as many times until you are convinced. Also, ask how you will be paid, what will be the situation if the interest rate changes (if it does, according to the chosen scheme), etc. Also, regarding the callable option, make sure to confirm all the features, i.e., if the interest lowers and your deposit is called and terminated, then you have the right to receive the full principal amount as well as the unpaid accrued interest.
It may sound a little silly, but remember, when it comes to money, it is wiser to sound silly before than repent later. So yes, confirm the date of maturity with the bank.
Please remember to ask the bank about the rules of penalty. Ask them how much you’ll have to pay if you withdraw your money earlier than term, how much will remain with you, etc. Some CDs have a stiff penalty, while some don’t have one at all. Put this down on paper.
Check Broker Information
This is for those who go opt to deposit through a broker. Verify the background of the broker. Check for his reputation, customers, style of working, bank contacts, etc. Keep abreast of what he intends to do with your money – which CD is he using, what is the rate of interest, what are the penalties, etc. Ask him how he maintains records, and ask him for copies of all related or relevant documents.
The rates for CDs vary from bank to bank, to credit unions and financial institutions. They need to confirmed while making the deposit itself. Also, they keep changing as per the market situation. They also help you decide which type to choose.
Investing money in the right way is very important. A CD can be a good option if you want to safely invest a small amount for a short period. Even then, please confirm all the terms and conditions associated with the account. Understand the factors to be considered, and act accordingly.
Disclaimer: This article is for reference purposes only and does not directly recommend any specific financial course of action.