Saturday, October 17, 2009

Certificates of Deposit (CDs)


A certificate of deposit, while technically a type of bank account called a time deposit, is more like a bond—a "product" that you buy for a specified amount and that earns a fixed interest rate until the end of its term. When the term is over, you can redeem your CD for the money you originally invested plus the accrued interest. Unlike other investments, CDs are federally insured up to $100,000. CDs are offered by traditional banks, online banks, credit unions.

How They Work
When you purchase a CD, you invest a fixed sum of money for a fixed period of time, called the term. CD terms can be almost any length, from 6 months to 20 years. In exchange for "lending" the bank your money (the principal), the bank pays you interest, typically at regular intervals, throughout the term. You get the total amount (principal plus interest) at the end of the term. However, if you redeem your CD before the end of the term (called its maturity), you typically have to pay an "early withdrawal" fee or forfeit part of the interest it earned.

Brokers
Traditionally, CDs were issued by local banks, but nowadays its common to also see them offered by brokerage firms or independent brokers, called "deposit brokers," who can sometimes negotiate a higher interest rate from the bank since they bring in so many customers. Note that deposit brokers do not have to be licensed, certified, or approved, so before engaging with one, do your research. Call your state securities regulator or check with FINRA's (the Financial Industry Regulatory Authority) Central Registration Depository to make sure 1) your broker is registered with them (allowed to trade securities) and 2) that they don't have any complaints filed against them.

You can find your state securities regulator at NASAA's (North American Securities Administrators Association) website or by calling (202) 737-0900.

To contact FINRA, call 1-800-289-9999 or use their online BrokerCheck tool

Also important when using a broker is to find out which institution issued your CD because there's a possibility that, if you're loaded and carry your other investments through that institution, your FDIC insurance might not cover everything. You see, the way FDIC insurance works is that its limited to $100,000 for each depositor at each bank. So if you've got $50,000 in one investment and $60,000 in another at the same bank, $10,000 or that is uninsured by the FDIC. Granted, considering this audience, this is highly unlikely, but it's good to know nonetheless.

One more thing--sometimes brokered CDs are held by a group of unrelated investors--each of them owning a piece of a large CD. For instance, a broker could offer you a 1-year $2,000 CD, but in reality you're getting 1/5 ownership of a 1-year $10,000 CD. The reason they do this is because banks usually offer higher interest rates for higher principals. Hence, it can be a good deal for you. Just be sure that you confirm with your broker exactly how your CD will be held and get a copy of the exact title of the CD. Always, always save all your paperwork. Not just with brokers or CDs but with any sort of investment.

Penalties for Early Withdrawal
Apologies for the vaguely dirty-sounding heading, but this is quite important. Before you invest in a CD, you need to make sure you can do without access to that money for the length of the term, because if you have to pull out (OK, that one was intentional), you could end up losing money. Always find out what the penalties are before you invest. And beware brokers who tell you their CDs have no early withdrawal penalties; it could be true or it could be a bit of a trick. You see, if you are sharing the CD with other customers, the broker has to sell your share to someone else. This may not be a problem if interest rates have gone down since you bought in, but if interest rates have risen, the broker might have to sell your portion at a discount, meaning that you lose some of your principal. It's not technically an early withdrawal penalty, but for all intents and purposes it is. (The reason that interest rate changes affect the ability of the broker to sell your portion is that CDs operate within a market. If your CD is locked in at 5% but rates have risen so that now there are other CDs available that earn 7%, no one is going to want to buy your lower-earning CD. Conversely, if rates have fallen, your 7%er might be quite an attractive buy. The moral of the story here is to ask questions and get everything in writing, so you know what you're getting in to.

Interest Rates
In general, the longer the term of a CD, the higher the interest it pays. While the CDs traditionally have had fixed interest rates, there are now also variable-rate CDs available. The variations all work differently, so you'll need to check with your bank or broker to make sure you understand how and when the rate will vary. For example, some feature a "multi-step "or "bonus rate" structure where the rates change over time according to a set schedule. For others, the rates change according to market performance; they're often linked to a specific market index, such as the Dow Jones Industrial Average or the S&P 500.

Before investing in a CD, whether variable-rate or not, be sure to get the interest rate (and how it will change) in writing from the bank or broker and find out how often interest is paid and when and how you will receive it.

Bankrate.com has a useful CD interest calculator where you can enter a deposit amount, an interest rate and type of compounding, and a length of time that the CD would be held, and the calculator will tell you the APY and what the ending balance would be. It also has a more general search function that gives you the basic info for CDs available in your area.

Money-rates.com is definitely the best CD (and savings account) search out there, updating every few minutes, and listing daily specials with rates way higher than usual. Some restrictions may apply on some of the specials. They also have separate pages with listings for short-term CDs (less than 1 year) and for longer term CDs. Good deals can be found. The search-by-state blog, however, is less helpful.

Callable and non-callable CDs
Some CDs give the issuing bank the right to "call" the CD back--effectively ending your agreement--after a set period of time. When that happens, the investor receives their full principle (the amount they paid for the CD) plus any interest that has accrued up until the call time. Banks won't always call a callable CD, but they're reserving the right. Because, naturally, investors do not want their investments to be terminated prematurely, callable CDs usually offer slightly higher interest rates to make them more attractive. It's a give-and-take situation. For instance, if interest rates fall, a bank might choose to call its higher interest CDs, and you'll be out of the game. However, if you've invested in a long-term fixed-interest CD and rates rise, you'll be locked in at that lower rate.

So, very basically, if you're worried rates might fall, you might look for noncallable, fixed-interest CDs; if you think they might rise, you might go for a callable, variable-interest CD. Either way, there's a risk, but compared to stocks, bonds, and mutual funds, it's fairly minimal.


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