Should You Buy A Certificate Of Deposit From Your Bank?

By Julie Bawden-Davis. May 7th 2016

A certificate of deposit (CD) is a low-risk savings product that requires investing a fixed amount of money for a predetermined time period. In return for locking your money into the account for a set term -- from a few months to several years -- the bank pays you a higher interest rate than you would earn from a standard savings account. Interest is added to the account on a periodic basis throughout the CD’s term.

What Is A CD?

When you purchase a CD, you invest a fixed amount of money for a specified period of time. The most common duration is between three months and five years. Generally, the longer the CD’s term, the higher the interest rate you receive on your money. While you can withdraw the money before the set term finishes, you pay a substantial early withdrawal penalty if you do so. When the CD matures, you receive the original amount you deposited plus accrued interest. At maturity, you can cash the CD in, let it automatically renew into the same length of term or roll it over into another term.

There are generally no fees to open a CD account. Minimum deposit requirements do exist and vary between financial institutions. Five-hundred dollars is often the lowest minimum you'll find. Accounts requiring higher minimums often pay better interest rates.

Types of CDs

Fixed Rate: Often referred to as a traditional CD, this account offers you an interest rate that stays constant throughout the term.

Variable Rate: Interest rates vary with this type of account, rising and falling according to variable rate indices.

Bump Up: If interest rates rise during the term of your CD, you can inform the bank that you want to "bump up" to the higher interest rate for the remainder of the term. Generally, the bump-up feature is only allowed once a term and bump up CDs usually start at a lower interest rate than fixed rate CDs.

Liquid: With this account, you can withdraw part of your deposit without paying a penalty. The trade-off for being able to pull out money is that the interest rate is usually lower than a traditional CD.

Investment Benefits

CDs are one of the safest investments you can make. At the end of the term with a fixed rate CD, you get back what you deposited plus a guaranteed amount of interest. Your investment is also protected if the bank where your CD is held fails because CDs are insured by the FDIC for up to $250,000 per account.

Fixed rate CDs also offer you a stable interest rate for a specified period of time. If interest rates fall during the term of your fixed rate CD, you continue to enjoy the higher interest rate locked in when you opened the account.

Investment Risks

Any financial investment involves some risk. With fixed rate CDs, there are potential opportunity costs. You risk the interest rates rising above the fixed rate and losing out on the earnings you could have received if you had invested your money elsewhere. Variable rate CDs also pose a risk, as you have no control over the prevailing interest rate.

Investment Strategy

Determining the length of time to open a CD depends on how long you want your money tied up and whether the interest rates are likely to go up or down. Fixed rate short-term CDs are often best when rates are on the rise, as they can be renewed at a higher rate. When interest rates look like they will be falling, it's best to purchase a long-term fixed rate CD, as an account with a locked-in rate will earn a higher return over the long run.

Timing is especially important for success with bump-up CDs. Since these accounts start at a lower interest rate than standard CDs, it's important that interest rates rise and make a bump-up possible.

Take advantage of timing by laddering, which involves staggering CD investments so that you open accounts with varied maturity dates and term lengths. For instance, instead of opening one 5-year CD for $20,000, which ties up all of your money for a long period, invest in four CDs of $5,000 with terms of 6 months, 1 year, 3 years and 5 years. This guarantees you steady access to your cash and enables you to take advantage of interest fluctuations. When one of your CDs matures, you can cash it in or reinvest it to keep the ladder going.

Additional Considerations

Knowing a CD's APR and APY helps you understand the potential for financial return. APR refers to the annual percentage rate paid on the CD. APY refers to the annual percentage yield, which indicates what is earned during the CD term as the money compounds. For example, a three-year CD with an initial investment of $1,000 and a 5 percent APR will yield $50 the first year, and then the second year the new account total of $1,050 will earn a compound interest of $52.50, and so forth.

Cautions

Beware of CD interest rates substantially higher than other lending institutions. Such accounts may not be backed by a legitimate lender or be federally insured. Also consider avoiding CDs with call features, which refer to the bank's right to terminate the CD after a set period of time if interest rates fall.

CDs offer a safe way to invest money over a specified period of time and receive more interest than you would in a regular savings account. Take a look at the wide variety of options available in CDs, and you're sure to find an account that fits your financial needs.

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