When does a certificate of deposit make financial sense?
There are three major types of cash savings accounts: the certificate of deposit, the money market or high-yield checking account, and a traditional savings account. CDs are the most restrictive but offer the best rates. Money market accounts and no-penalty CDs fall somewhere in between, and a traditional savings account offers the lowest rate and the greatest access to funds. Naturally, the biggest question in choosing an account is how soon you may need your money back. If you are hit with an early withdrawal penalty, you may lose the value of the higher interest rate and then some. If you have more to invest, you can overcome the liquidity issue of CDs by employing a ladder strategy, where you purchase certificates on a rolling basis so that one is always maturing soon. Finally, even though a CD is a deposit account, you won't be able to make regular, ongoing deposits as easily as you could with a savings or money market account. CDs may also impose minimum deposit limits, making them less accessible to those with inconsistent or lower savings levels.
Different types of certificate of deposit products
These are CDs in an amount of at least $100,000. They are long-term investments and have truly superior rates, making them an attractive 'risk-free'
option for wealthier investors.
Brokered CDs are sold by financial institutions other than banks. Because brokers have access to a larger market, they can often achieve higher
interest rates than those offered by banks. Brokered CDs usually have high minimum deposit requirements and are tradable in a secondary market.
One of the disadvantages of a CD investment is the risk of being trapped at a lower interest rate if rates go up during your term. A bump-up CD offers
the ability to 'bump up' your interest rate--usually just once--to capture the gains of rising rates.
The bank may 'call' a callable CD even before it reaches full maturity and force you to cash out early. This means you may lose out on some interest if
and when the bank exercises their option to call your CD.
This is like a regular CD, but it is held inside an individual retirement account (IRA), which means that the deposit and interest are tax-advantaged.
IRA CDs usually have high initial deposit requirements, but offer very competitive interest rates.
What to remember when choosing a certificate of deposit product
- As mentioned above, some longer-term CDs retain 'call' options for the banks that issue them. If your CD is subject to a call option, then the bank may be able to terminate the contract early (after a year, for example) if interest rates fall. If interest rates go up instead (making your CD's rate relatively inferior), you won't have a similar option to bail out of the CD.
- Different CDs have different payout programs. Find out whether you'll be paid monthly, annually or otherwise.
- Some CDs have a variable interest rate. Ask whether an attractive rate is introductory or fixed.
- Most CDs impose penalties for early withdrawal. Find out what they are before investing. Read about strategies for avoiding early withdrawal penalties here. Or, check out some no-penalty CD options.
- CDs are insured by the federal government for up to $250,000, making them a very safe way to save cash. Make sure that your product is covered before signing up, and find out more about deposit insurance here.