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.
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.
In addition to regular CDs, whose terms are rarely longer than five years, banks may offer
long-term, high-yield CDs that pay a much higher rate of interest for terms as long as 10 or 20 years. These CDs may be callable, which means that the bank has the right to terminate the CD and pay you back your principal plus the interest earned to that point. This usually happens if your CD is paying higher interest than CDs currently on the market, and it means you would have to reinvest your principal at a lower rate than your old one paid. However, unlike the bank, you don’t have the right to end a CD contract if the situation is reversed and your CD is paying less than the current market rates.Aside from purchasing CDs directly from a bank, you can also purchase CDs from a stockbroker or other investment professional. Brokered CDs may have longer holding periods, be more complex, carry more risk, and include sales charges or fees.
If the fee is modest and the CD is paying a higher rate than you could find on your own, you may come out ahead. But you should take the fee into account. Although most brokered CDs are bank products, some may be securities–and won’t be FDIC insured.Also, if the bank issuing the CD is FDIC-insured and the CD is a bank product, remember your account value will only be insured up to $250,000, and you must be listed as the CD’s owner, otherwise if the bank fails, you could suffer a loss.
As with any investment, always ask. Don’t assume because you know what that makes me and you when you do. Up next, stocks.
Patricia Stallworth, CFP® and CDFA, is the president of PS Worth, a financial education company, the author of Minding Your Money, and the host of the Minding Your Money Minute™. Learn more by visiting MindingYourMoney.net.