Learning the ABCs of CDs

Not all certificates of deposit are created equal

CDs are time deposits, designed to hatch a return of principle plus interest at a future date

Before you invest, take some time to understand all of your options beginning with the different types of investments and the characteristics of each. As I wrote last week, there are three basic types of investments – cash, stocks, and bonds. All other investments represent a variation of one or more of these basic types. This seven-part series explores each type in detail.

This week, we continue the discussion on Cash Investments.

Certificates of Deposit (CDs)

Most people tend to think of CDs as simple investments but they can get complicated. Not all CDs are created equal so it will be important to know the ins and outs of any CDs you may be considering. But first the basics.

Certificates of deposit are time deposits. When you choose a CD, the bank accepts your deposit for a fixed term—usually a preset period from six months to five years—and pays you interest until maturity. At the end of the term you can cash in your CD for the principal plus the interest you’ve earned, or you can roll your account balance over to a new CD at the current interest rate. If you cash in your CD before it matures, you’ll usually pay a penalty, typically forfeiting some of the interest you’ve earned.

In the past, each CD paid a fixed rate of interest over its term. But today you can also find variable rate CDs, sometimes called market rate CDs. With these accounts, the interest rate may rise and fall with changing market rates or be readjusted on a specific schedule. If the current rate is low, it may make sense to purchase a variable CD. That way, if interest rates rise, you won’t miss out on the rate increase. On the other hand, if you expect rates to fall in the future, it may make more sense to buy a fixed-rate CD to lock in the higher rate for a specific term.

One alternative to purchasing single CDs is to create a CD ladder by purchasing several with different terms. You might start by dividing the amount you plan to invest in CDs into four equal amounts and purchasing four CDs with varying terms—say three months, six months, nine months, and one year. As each CD matures, you replace it with a one-year CD, so you have an amount to cash in or reinvest on a regular schedule. If you use a longer ladder, so that your CDs mature on an annual basis instead of a quarterly one, you would never have all your money invested at the same rate, which would allow you to avoid locking in a large sum at a low rate.

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