-
Function
CDs function by allowing you to harness the time value of money. Interest is compounded, meaning you will earn interest on top of the principal. If you deposit $1,000 at the beginning of October, and the CD earns $30 in interest that month, then starting in November you will be earning interest on $1,030. You may also be permitted to take the interest out of a CD on a regular basis. For some investors, this interest income is a crucial source of regular revenue.
When your CD matures, or comes due, the bank notifies you, normally by letter. During the CD maturity period, you may withdraw the CD without penalty or change the term. If you do nothing, the CD may "roll over" to the previous term length, but at the bank's current rate for the term, not necessarily the original rate.
-
Types
Investors in CDs enjoy the benefit of many terms and types. Flexibility is a key feature. Terms may be as short as seven days (although only large deposits, normally $100,000 or more, may be accepted) or 10 years or longer. In general, the longer the term, the higher the rate, although the bank may offer an attractive rate on a popular term, say one year, to attract more depositors.
In addition to various term lengths, CDs may have additional features. Some CDs may be "callable," giving the financial institution the right to end the term at their discretion. Other certificates offer the option to "bump" the rate; depositors may, over a term, request a higher rate on the CD if the bank is offering that rate on new deposits. In other words, you have a two-year CD at 2 percent. A year later, the bank starts offering a one-year CD at 2.25 percent. The bump option would allow you to receive the 2.25 percent rate on your current deposit, without changing the term.
Also note that Individual Retirement Accounts, or IRAs, can be structured as CDs. IRAs have different rules than traditional CDs, however, so make sure your banker clearly outlines withdrawal parameters and tax implications of your IRA CD.
-
Strategies
For holders of multiple deposit accounts in particular, CDs offer some solid investment planning strategies. One of these plans is "laddering," where you structure your CDs to come due at multiple times to offer you the most flexibility to renegotiate rates or to provide access to your funds. You may decide to ladder a $9,000 investment into three separate CDs, each coming due a few months apart.
In addition, the FDIC rules will play a crucial role for the CD investor. The FDIC likes to remind people that no U.S. investor has ever lost a penny on an FDIC-insured account, a strong selling point for CDs. Basically, savings accounts like CDs are governed by FDIC limits (traditionally $100,000 per account, per bank, except for IRAs, which have an insured limit of $250,000). Strategy comes in when investors who have funds in excess of FDIC limits structure their CDs and other savings accounts by titling them differently. The FDIC has a website dedicated to showing families how to set ownership on deposit accounts so they are fully insured.
-
Considerations
One of the major considerations for CD investors is the reality of rates. Compared with other investments, rates on CDs are relatively low. This means your CD rate may not exceed the rate of inflation. In other words, if you buy a two-year CD at a 3 percent rate, and the rate of inflation for that two-year period is also 3%, you are gaining nothing in real terms. In addition, in times of recession the government may lower interest rates. That is great for borrowers but bad for savers, since the low rates on CDs become even lower.
You may want to think about withdrawal penalties. Before investing in a CD, you should ask yourself if there is even the slightest chance you will need to access the funds in question, since you will be penalized--perhaps even cutting into your principal investment--if you withdraw early.
