CERTIFICATES OF DEPOSITS (CDs)

Overview

The Certificate of Deposit (CD) is an investment where you receive a fixed rate of interest for a specified period of time. CDs are available through banks, savings and loans, credit unions, and brokerage firms. Access to your money is restricted and may not be available unless you pay an early withdrawal fee. CDs usually require a minimum investment that is higher than checking or savings accounts.

When you invest in a CD, you receive a fixed rate of return on funds that are invested for a specified length of time. That’s why CDs are viewed as a fixed-income investment.

The CD is one of the safest investments you can make. Generally, your investment is protected by the FDIC. Brokerage firms usually offer CDs that are covered by the FDIC. These firms are also covered by insurance through the Securities Investor Protection Corporation.

 

Selecting a CD

Term until maturity

When you invest in a CD, you pick the term until your investment matures. At maturity you’re able to take your money without a penalty. The term may be shorter than your college term or longer than it takes you to get a degree.

Most financial institutions offer a variety of terms, each paying a different interest rate. You might need to choose a CD offering any of the following terms:

  • 1 month
  • 3 months
  • 6 months
  • 12 months
  • 18 months
  • 24 months
  • 30 months
  • 36 months
  • 60 months or much longer

Your choice of the term for the CD you invest in is based on:

  • When you’ll need the money
  • Where you think interest rates are headed

Interest Rates

The Federal Reserve, or the Fed as the financial wizards call it, is in charge of our nation’s money supply. At the risk of being overly simplistic, here is the Federal Reserve’s strategy:

  • If inflation is escalating, the Federal Reserve will usually raise interest rates. Rising interest rates usually curb consumer spending by encouraging people to save money and earn interest and by discouraging purchases on credit.
  • If it looks like the country is headed for an economic downturn, the Federal Reserve will normally lower interest rates.

The interest rate on CDs fluctuates widely from year to year. For that reason, it’s difficult to decide how long to tie up your money. If you think interest rates are going higher, you may want to select a CD with a short term or an investment where you’ll have easy access to your money. If and when interest rates rise, you will be in a position to invest in a new CD.

There will be times, when the interest rate paid on CDs is low, the return on your investment will barely keep up with inflation. There will be other times, however, when CD rates far exceed the rate of inflation.

 

Tips & Common Mistakes

Common mistake: Investing your emergency fund in a CD

When you invest in a CD, you agree to lock in your money for a specified term. There is a steep penalty if you need to withdraw your money before the CD matures. This is called a premature withdrawal penalty. Therefore, you should not keep your emergency fund in a CD.

Brokerage firms offer CDs that appear to have no early withdrawal penalties. If you need to cash in the CD before the maturity date, your CD is sold to another investor. Although you don’t pay a penalty, you incur selling costs (broker fees) and your CD may be worth less than you invested.

Tip: Shop around for the best rate

It is important to shop around for the best interest rate. Many financial institutions advertise their rates. You’ll often find higher interest rates to attract new customers. You can also shop around on the Internet for higher CD rates at Web sites such as www.bankrate.com and www.emoneycentral.com.

Just because a financial institution gave you a great rate on a CD when you made your first investment doesn’t mean it will treat you as well when it comes up for renewal. Each time a CD matures, you should shop around again for the best rate. It is easy to move your money from one financial institution to another.

 

Getting Started

If you’re ready to invest in a CD, here’s how to get started:

  1. Make sure you have enough to invest. Usually, you’ll need at least $500, but there are exceptions.
  2. Make sure you won’t need your money before the maturity date. Otherwise, you’ll be forced to pay a premature withdrawal penalty.
  3. Make sure you compare rates. You may get a better rate from a bank if you have other accounts with them, such as a checking account.

After shopping around, filling out the paperwork in person or online is easy. You write a check for the amount you want to invest and fill out some forms supplied by the financial institution you’ve decided upon.

If you’re unsure about how much to put in a CD and for how long, consider the “laddering” strategy. With laddering, you divide up your investment and spread it among CDs with different maturity dates. Laddering helps you avoid locking up all of your money at what might turn out to be an extremely low interest rate and it ensures that some of your money is available without a penalty at regular intervals.

For example, if you have $5,000 to invest, you might invest $1,000 in five CDs with different maturity dates. As each CD comes due, you can commit to longer terms if interest rates are higher and you don’t need the money. When you ladder CDs, you should arrange for them to mature on a regular basis, so some of your money will be available to spend or reinvest.

 

FAQs

What term for a CD is right for me?

Before choosing the term for your CD, ask yourself these questions:

  • When will I need the money?
  • Does it look like interest rates are going up or down?
  • Do I have other money I can use in case of an emergency?

Choosing the term for your CD is an example of how you make investment decisions and manage your money. If you think interest rates will go up in the next few months, you should invest in a short-term CD rather than a longer one.

Remember, though, that you could be losing money if you hold off on investing while you’re waiting for interest rates to go up. For example, if you leave your money in a no-interest checking account while you’re waiting for interest rates to go up, the higher rate won’t make up for the period of time when you receive no return on your investment.