Certificates of Deposit

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With short-term interest rates above their lows, the popularity of highly liquid, insured accounts has returned.  Bank savings accounts are an option.  An earlier post focused on these and their like.  Because banks and other financial institutions pay a higher rate the more money you are willing to commit and the longer you are willing to leave it, certificates of deposit, (CDs) present an attractive alternative.

CDs commit you to leave a set amount, for a set time, with the financial institution for an agreed interest rate.  Because the financial institution can better plan what to do with the money than with a savings account (where the institution cannot anticipate how much and when you may withdraw), it is willing to pay a higher interest rate.  Financial institutions sell CDs in amounts of $1,000, $5,000, $10,000, up to $100,000, and sometimes more.  Like bank accounts, the FDIC insures these up to $250,000.  Some brokers also offer CDs.  These are not FDIC insured, but often the issuers make insurance arrangements with a private insurance company.

If you decide to buy a CD, make sure you can leave the money for the entire term, because there’s usually a penalty for early withdrawal. Some banks offer “liquid CDs”  –– these allow the withdrawal of funds without penalty before the stipulated term, but they usually pay lower rates than conventional CDs.  If you buy your CD through a broker, you may have the option to sell it back before its term expires, but this almost always lowers the interest rate.  (That broker will then resell the CD on what is called the “secondary market.”)

Some CDs offer flexible rates that rise if market interest rates increase. Typically, these guarantee that the rate originally quoted to you will not be lowered. Some banks will also let you set the terms of your CD.  These so-called “designer CDs” can be useful for savings aimed at college tuition, for instance, or other expenses where you know the approximate date you will need the funds.  These, too, often pay a slightly lower rate than conventional CDs, though typically not as low as liquid CDs.   Note that these flexible and liquid CDs have become less common in recent years.

Shop around.  CDs vary considerably from one institution to another, and rates can differ by as much as a full percentage point. The Internet offers the saver a great tool for making such comparisons.  All bank websites have information on all their services, including the rates on CDs and the associated conditions on term, early withdrawal, and the like.  Be careful: marketing often make things look more attractive than they really are.  Here are a few points to consider:

  • The tease: Some CDs offer a relatively high interest rate up front but after time pay a much lower rate.  Know how long the higher “teaser” rate will last.
  • How the bank/broker treats maturity: Will you receive timely notice when your CD is about to reach term and can you then roll it over automatically into another, similar CD, or can you stop the process?  Be sure you understand the rate offered by such a “rollover.”
  • Calculation of interest: Know whether the interest rate quoted is simple or compounded.  The best you can do with a simple rate is what is quoted up front.  A compounded rate, However, will calculate the interest periodically and post the interest to your account.  Because each interest calculation will include the interest previously paid, you will effectively earn interest on the interest, as described in several earlier posts –– a far more attractive arrangement than receiving simple interest alone.  For instance, a one year a CD that compounds daily will pay you 0.15 percentage points more for each 1 percent of quoted interest.  When compounded that way, a one-year CD quoting, say, 1 percent would effectively pay 1.15 percent.  A CD quoting 2 percent would effectively pay you 2.31 percent.  Though it might not seem like a lot, a $50,000 CD quoting 2 percent interest, would earn an extra $155, enough to justify making sure you’re getting the compounded rate.

 

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