Certificates of Deposit: Tips for Savers
Investors searching for relatively low-risk investments that can easily be converted into cash often turn to certificates of deposit (CDs). A CD is a special type of deposit account with a bank or thrift institution that typically offers a higher rate of interest than a regular savings account. Unlike other investments, CDs feature federal deposit insurance up to $250,000*.
Here’s how CDs work: When you purchase a CD, you invest a fixed sum of money for fixed period of time – six months, one year, five years, or more – and, in exchange, the issuing bank pays you interest, typically at regular intervals. When you cash in or redeem your CD, you receive the money you originally invested plus any accrued interest. But if you redeem your CD before it matures, you may have to pay an "early withdrawal" penalty or forfeit a portion of the interest you earned.
Investors may now choose among variable rate CDs, long-term CDs, and CDs with special redemption features in the event the owner dies. Some long-term, high-yield CDs have "call" features, meaning that the issuing bank may choose to terminate – or call – the CD after only one year or some other fixed period of time. Only the issuing bank may call a CD, not the investor. For example, a bank might decide to call its high-yield CDs if interest rates fall. But if you’ve invested in a long-term CD and interest rates subsequently rise, you’ll be locked in at the lower rate. Before you consider purchasing a CD from your bank or brokerage firm, make sure you fully understand all of its terms. Carefully read the disclosure statements, including any fine print. And don’t be dazzled by high yields. Ask questions – and demand answers – before you invest. These tips can help you assess what features make sense for you:
- Find Out When the CD Matures – As simple as this sounds, many investors fail to confirm the maturity dates for their CDs and are later shocked to learn that they’ve tied up their money for five, ten, or even twenty years.
- Before you purchase a CD, ask to see the maturity date in writing.
- Investigate Any Call Features – Callable CDs give the issuing bank the right to terminate the CD after a set period of time, but they do not give you that same right. If the bank calls or redeems your CD, you should receive the full amount of your original deposit plus any unpaid accrued interest.
- Understand the Difference Between Call Features and Maturity – Don’t assume that a "federally insured one-year non-callable" CD matures in one year. If you have any doubt, ask the sales representative at your bank or brokerage firm to explain the CD’s call features and to confirm when it matures.
- Confirm the Interest Rate You’ll Receive and How You’ll Be Paid – You should receive a disclosure document that tells you the interest rate on your CD and whether the rate is fixed or variable. Be sure to ask how often the bank pays interest – for example, monthly or semi-annually. And confirm how you’ll be paid – for example, by check or by an electronic transfer of funds.
- Ask Whether the Interest Rate Ever Changes – If you’re considering investing in a variable-rate CD, make sure you understand when and how the rate can change. Some variable-rate CDs feature a "multi-step" or "bonus rate" structure in which interest rates increase or decrease over time according to a pre-set schedule. Other variable-rate CDs pay interest rates that track the performance of a specified market index, such as the S&P 500 or the Dow Jones Industrial Average.
- Research Any Penalties for Early Withdrawal – Be sure to find out how much you’ll have to pay if you cash in your CD before maturity.
- Find Out About Any Additional Features – For example, some CDs offer a death benefit that allows a CD owner’s heirs to redeem the CD without penalty when the owner dies.
The bottom-line question you should always ask yourself is: Does this investment make sense for me? A high-yield, long-term CD with a maturity date of 15 to 20 years may make sense for many younger investors who want to diversify their financial holdings. But it might not make sense for elderly investors.
Excerpt from the FDIC article Certificates of Deposit: Tips for Savers
* New Deposit Insurance Limits
On October 3, 2008, FDIC deposit insurance temporarily increased from $100,000 to $250,000 per depositor through December 31, 2009. For more information visit http://www.fdic.gov/news/news/financial/2008/fil08102a.html