Understanding Certificate Of Deposits

A CD can be simply understood as a financial instrument that offers a term-based assured return to the owner. By getting a CD, you basically agree to lend a certain amount of money (principal) to the issuing institution for a fixed period of time (term). This is why they are referred to as a type of Term Deposit.

The institution lends this money at higher rates or invests it to earn a profit. To offer you a financial incentive, the institution promises to pay a fixed (pre-determined) Rate of Interest (ROI). Although, CDs offering variable ROIs have been introduced, the traditional fixed-ROI CDs are the more popular choice. At the end of the mentioned time period, you get your Principal and the accrued interest.

Why CDs For Investment?

Economic cycles tend to vary, sometimes too frequently for your comfort and it becomes difficult to seek a secure mode of investment. Even the share markets tend to undergo the usually up-and-down cyclical phases. What’s more, saving deposits don’t have very appealing interest rates either. In such a scenario, a Certificate of Deposit comes across as the most secure way of investing your money and earning assured interest rates, which in the long-term are almost at par with other lucrative market-related investment schemes.

Compared to a typical savings deposit, a CD proves more profitable, though they can’t be operated with as much flexibility. Another feature that sets apart CDs is the pre-determined denomination in which they are issued. For example, CDs could be issued by a bank in pre-defined denominations of $500, $1,000 and $5000.

Purchasing CDs: You can purchase a CD for any period of time. The usual options extend from a few months to as long as five years. It is advised to purchase CDs for longer periods of time, as this allows an earning of a substantial amount of interest. However, purchasing CDs for more than five years is seldom recommended, because a bank’s own interest rates could undergo major fluctuations and you could find yourself stuck with a low-earning CD for a very long period. Again, various banks and financial organization offer varying rates of interest, so you have to do a personal research before making your decision.

Purchasing a CD from a bank is the norm but they can also be purchased through brokerages. Some banks may have minor stipulations, such as the presence of a banking account in your name, to issued a CD. However, the trend varies across the banking sector and some institutions are liberal enough to even entertain online applications and issue CDs.

Avoiding Penalties: You can incur a Penalty Fee if you request the institution to return you the money before the fixed time period expires. Therefore, it is always recommended not to withdraw your money prematurely from a CD, unless it is absolutely unavoidable. This is the only obvious drawback with CDs, i.e. your capital is no longer liquid and you are discouraged from making withdrawals.

Certificate Of Deposit

A Certificate of Deposit (CD) is a term based deposit or a promissory note issued by bank for a fixed interest rate, insured by the Federal Deposit Insurance Corporate (FDIC). An investor can purchase a CD for any denomination and earn the principal plus interest after term maturity. The investor also has the option to withdraw money from the CD before maturity if required, at the cost of some penalty. The main advantage of CD is that it offers higher rates than savings account and Treasury Bills.

Money Markets

Money Markets are deposit accounts that offer a relatively higher rate of interest as compared to a savings account. Money Market accounts can be opened at any financial institution. The difference between a CD and money market account is that the latter functions as a checking account. As an investor, your money is not tied up and you can withdraw your money as needed without incurring any penalty. In some cases, you may be required to give a short notice.

Some restrictions that differentiate the operation of money markets from checking accounts are the requirement of high minimum balance and a limit on number of monthly transactions. If you violate any of these restrictions, you will be charged very high service fees. Like CDs, Money Markets are also insured by FDIC and are considered a relatively low risk investment. They offer slightly rates slightly lower than the CDs but still higher than the savings account. Money Market account rates are determined by the amount deposited, higher the amount of investment, higher the rate. The interest rates are not determined by duration of investment.

Choosing Between The Two

Money Market for short term and higher liquidity: Clearly, money market is a better option for short term investment as it offers all the features of a CD as well as acts as a savings account. If you think you can work with the restrictions provided by banks/financial institution around the money market account, then this is recommended as a form of investment. Another advantage of investing in money markets is that if the market is doing well or the interest rates improve, you can withdraw this money and invest in better schemes like stocks, mutual funds etc. As interest rates are determined by the amount deposited, big investors gain more out of money markets.

CDs for long term and lower liquidity: If you can have surplus money that will not be required for a long duration of time, than CDs are good as they offer a higher rate of interest than money markets.

Judge Your Compatibility With CDs

Not every individual is suited for investing in Certificate of Deposits (CDs). The reason is simple — every depositor has a different mindset regarding his/her investments. Only those investors who have the patience and the financial stability to purchase a CD and then leave it untouched until its maturity are suited for such investments. Individuals who are habitual in conducting frequent transactions from their investments or those looking for quick returns aren’t suited for CD type of investments.

CDs issued around the world incur penalties if money is withdrawn from them before the maturity period and it doesn’t make sense to invest money and then lose on profits by paying regularly paying penalties.

What Are Your Financial Goals?

Investors who seem fascinated by the double-digit interest rates that offered by market-based investment instruments should refrain from purchasing CDs. The lure of stock market lies in quick and sometimes extremely high profits. Both these features are absent in CDs. Instead, investing in Certificates offer security and long-term stability and not the dynamism that is seen among market–centric financial portfolios. However, none of the market-based investments, like annuities or mutual funds can guarantee risk-free returns like a CD because their profits are linked with the volatility of the stock markets.

Conclusion: you should consider investing in CDs only if you value the worth of secure, long-term and medium-yielding investments.

rocurement Of CDs: Bank Or Brokers?

One very obvious fact is that CDs issued by banks are perhaps the safest ones when it comes to investing your money. CDs that are issued by a bank are a form of bank deposit and hence they are insured by the FDIC — Federal Deposit Insurance Corporation. This one single factor makes bank CDs much safer than those purchased through brokerages. However, over the last decade some brokerage firms too have gained a reputation of being dependable. Still, you need to double-check upon certain things when investing in CDs purchases through a broker:

• Brokered CDs are usually sold through commission-based intermediaries called Deposit Brokers who don’t need to have any particular licenses or registrations with federal agencies. Hence, you need to verify the authenticity of the broker. The best ones are those who are affiliated with some reputed investment firm.

• In traditional CDs, issued by banks, the issuing authority lies solely with the bank itself. However, brokered CDs may have an assortment of some small investors, each owning a percentage of the total CDs issued. Your broker should tell you whether these investors are capable of paying back your principal amount in case you want to redeem your CD before time.

Ownership Of CDs

You can invest in CDs through either of the following modes of ownership:

• Individual name or Single ownership — owned by one person

• Joint ownership — this is in two forms: with survivorship or without survivorship

In joint ownership of a CD between with survivorship (usually among two holders), the death of one holder means that the entire CD is transferred in the name of the other owner. In cases of joint ownership without survivorship (usually with more than two holders), such privileges are withdrawn and there is no automatic division of the invested funds among the multiple holders in case any one passes away.

Investing in a CD overcomes all the apprehensions that come with investing in investments related to the stock markets, unless you choose for the not-so-popular Bonus Interest or Callable CDs. Even then, all CDs provide greater insulation against market fluctuations and a greater security cover. At the time of your CD’s expiry, you can simply claim the interest that was promised to you along with the principal amount.

Safety Insured

What makes CDs a uniquely secured way of investing your money is that they are termed as deposit accounts by the Federal government. This means that CDs purchased from banks are insured by the FDIC — Federal Deposit Insurance Corporation. This is the chief Federal body in the US that insures various types of bank accounts. The maximum insured amount for a CD has been set at $100,000 by the FDIC and for the retirement accounts, the limit has been raised to $250,000.

Know Your Facts

CDs have been sometimes discriminated for offering negligible liquidly and offering rigid interest rates over extended periods. However, CDs aren’t static in terms of offering liquidity for your capital as long as you have planned a proper strategy regarding your investment portfolio. You should be able to plan your investments in CDs in such a way that:

• You don’t have to break your CDs before time and pay penalties (i.e. you maintain sufficient liquidity)

• You benefit from interest rate fluctuations (i.e. you have the liberty to invest money at higher interest rates)

You Don’t Have To Suffer For Safer Investments

If the two problems, mentioned above, are resolved, CDs become perhaps the wisest option for investments. This can be done through an approach called ‘Laddering’. It is a simple method of organizing your CD investments that makes them safer and more profitable.

How Is Laddering Done?

The interest rates offered on CDs vary over a period of time. Banks will determine these rates based upon Federal guidelines and their own financial performance. This means that you should use your CD-related investments in such a way that you can benefit every time the rates rise. Laddering simply means that you don’t invest all your money in a single sort of CD. Instead, you should purchase different CDs spread over a range of time. This means that you purchase CDs for different terms.
Example: If you have a total of five CDs, each can be invested for varying terms, i.e. for five years, three years, two years, one year and seven months.

What Is The Advantage?

This helps you to beat any period of low interest rates. Since you have different CDs maturing at different intervals, you can re-invest them at the new (i.e. higher) rates being offered. Again, after small intervals of period, you keep getting money to spend (liquidity) as the various CDs keep maturing at their respective but different maturity dates. This approach removes every conceivable problem related with CDs and you still don’t compromise on the safety of your investment.

ose Wisely - Make Comparisons

In order to make comparisons between the CD rates being offered by various institutions, it is vital to understand the following terms:

• Initial Deposit — amount initially invested in purchasing the CD

• Time Period — time taken by the CD to mature
• Interest Rate — the interest rate offered by the issuing authority

Note: this should be the actual interest rate that would be offered to you at the time of purchasing a CD and not the APY (Annual Percentage Yield)

• CD Rate Trend Index (RTI) — many financial advisors tend to provide weekly analysis and reports on the CD rates being offered on Callable or Bonus rate CDS (linked with market investments). These predictions are usually provided in the form of an RTI Survey.

What Is Annual Percentage Yield (APY)?

This is the eventual interest that would be earned within a year on a CD. APY is also a secondary consideration while comparing the performances of CDs among various financial organizations because many of these advertise their Deposit Rates in the form of APY.

The value of APY is dependent on:

• The frequency at which the ROI is compounded (Compounding Frequency)

• The committed (mentioned in writing) interest rate

What Is Compounding Frequency?

Compounded interest can be simply understood as the bigger interest generated on the CD’s accumulating value, i.e. the interest generated on the sum of your CD’s principal amount and the interest earned.

Every bank has a different frequency at which the compounding is done, i.e. the number of times the CD’s interest income is added to the principal amount. Obviously, the higher this frequency, the faster will your accumulated interest rise and more would be the amount that you gain from the additional profit earned. Therefore, at the time of comparing CD rates, remember to check the compounding frequency that is being offered.

Online Sources - Self-Approximation Of Deposit Rates

There are many websites that can help you calculate the interest rates and the total amount that would be due to you at the end of a certain period of time. Many financial websites lists these calculations in the form of ‘CD Rate Calculators’ and these are usually offered for free. All you need to do is just enter the basic numbers like the amount you want to invest and the Calculator will provide all the permutations and combinations including figures like the APY.

These websites also have an updated list of the highest-yielding and more popular CDs. However, these are basically self-help tools that provide instant but approximate, illustrative figures. These can be used to gauge the most probable deposit rates.

Professional Help

In order to be sure about your decision, you would have to seek personalized help from the institution of your choice. You can also seek the help of qualified financial professionals including chartered analysts, financial planners, brokers or personal finance advisors who provide precise solutions, but they would charge for their services.

CD Rates Offered At Credit Unions

Credit Unions function in a way that is a little different from banks although the basic features are similar. These are non-profit organizations and enjoy more liberties when it comes to investing an investor’s funds and thus they offer slightly higher deposit rates than most commercial banks.

A CD will have maturity date, a specified fixed interest and can be of any denomination. The term of deposit can vary from one month to five years. While investing, it is always good to know the pros and cons of the investment option.

Advantages Of CDS As An Investment Instrument

• CDs typically offer a higher rate of interest than Treasury bills and savings account due to the higher risk associated with them.

• As the rate of interest is fixed, your return on investment is ensured despite the rate fluctuations in the market.
• CDs are insured by Federal Deposit Insurance Corporation and hence are a good investment option for single income households and retired folks. CDs are a risk-free investment.
• The return on CDs is assured and helps in financial planning.
• It’s very easy to set up a CD. One needs to just walk to their local bank and request for purchase of CD. Money from the existing savings account will be ear-marked against the CD that has been purchased. The only thing to be made sure that the bank is FDIC ensured.
• CDs can be purchased and sold through a brokerage firm. This way you can encash the CD before the maturity term without paying the penalty.

Disadvantages Of CD As A Money Market Instrument

• Money is tied down for long durations of time. Though the investor can withdraw money, he has to generally incur penalty in terms of some amount of loss of interest on the deposit amount. You can get a waiver on the penalty in case of special circumstances like disability, death or retirement.

• As the rate of interest is fixed, it is difficult to change or to take advantage of the market situation when the market rates are favorable. You will not be able to get an interest rate that favors inflation.
• Though the return rate is higher on CDs than savings account, it is much lower than other money market instruments where you can make possible investments.
• According to the federal regulations, FDIC will insure CDs up to the maximum amount of $100,000 in a single financial institution. So if you want to invest more than &100,000 you will have to invest in separate CDs in different banks!

Choosing A CD: Callable Or Conventional?

Besides the conventional CD that provides a fixed rate of interest (ROI), there is another type, called Callable CD. This is a Certificate of Deposit where the interest rate isn’t precisely fixed. Instead, it can increase or decrease over a fixed period of time. ‘Calling’ here refers to a privilege enjoyed by the issuer to cancel the CD after a certain period of time, i.e. the CD can be ‘called’. There is a fixed time period up to which these CDs are non-callable. It is very difficult to forecast when would an issuing authority will ‘call’ (redeem) a CD but usually certain indications before redeeming them are given in advance.

Maturity Of CDs

Financial institutions have different facilities on offer when a Certificate matures. Ideally, it is the investor who should claim the Certificate at the time of maturity or leave some specific instructions.

• Some investors inform the bank to automatically transfer the total amount on maturity from their CDs to the savings account in their name.

• Some banks have a policy of automatically re-investing the amount due on maturity into a new CD, if the investor doesn’t come forward at the time of maturity. This is done by issuing a new CD at the original rate of interest or at the latest applicable rates.
• Many banks have the facility where customers are reminded in advance about an impending CD that is about to mature. This is something that you would have to check at the time of purchasing a CD. Other added features could include timely interest statements and constant reminders via SMS or e-mails.

Understanding Interest Rates

The common notion is that CDs offer a fixed rate of interest. For general understanding, that does make sense. Most of the banks will offer only fixed ROI over a period of time. However, Callable or Multi-step CDs offer a bonus-centric interest rate. Here, interest rates are termed as bonus rates because they are bound to increase every time the stock markets climb. For example, some banks have variable CDs whose interest rates vary according to the Dow Jones Industrial Average Index. However, they present a riskier option when compared with conventional CDs where you receive a fixed ROI, irrespective of the stock market conditions or economic fluctuations.

Interest Payment

At the time of maturity, the owner of a CD receives two things: the principal amount which is basically the amount for which the CD was purchased and the interest generated. Now, there are some options in terms of collecting this interest. Some investors choose not to take the interest that is earned on a monthly or annual basis. They let it accrue in the certificate account, along with the principal. This means that over a period of time, you earn interest on the sum of your principal and the interest that is being generated. This is the preferred option — in it the ROI is calculated on a compounded basis.