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Fact: Banks are constantly trying to “seduce” people into putting their money into the bank. For this, they offer their clients to pay them for doing so. This is known as a deposit.
The following chart from the 2019 FED Survey of Consumer Finances shows the average amount families invest in Certificates of Deposit have grown tremendously between 2001 and 2019. In 2001, the average was just $54.10 and it steadily increased every three years. It peaked in 2010 before steadily increasing again to a high of $101.95 in 2019.
Are certificates of deposit a good investment option for you?
The answer is not simple; it depends on the bank, the terms they offer and you as an investor. On the positive side, CDs give people a steady and predictable income in the form of interest rate. On the downside, it “locks” your money for a set period of time – three months, six months, a year, etc.
What are CDs, how do they work, what are their pros and cons, how many types are there? Let's explain.
What Are Certificates of Deposits (CDs)?
A certificate of deposit (CD) is a contract between a bank and a depositor for a fixed period of time. The latter is called term. The depositor entrusts his money to the bank and for this, it pays an interest rate to the deposit owner.
Usually, people buy deposit accounts because they have some spare money they do not need in the near future.
If the term of your CD is one year after it expires the bank will pay the interest rate on the money. A deposit owner should pay taxes on the returns unless the account is tax-free or tax-deferred. Bear in mind that CDs are low-risk and low-return investments and are not suitable for people who need cash at the moment.
Well, if your bank is insured by the Federal Deposit Insurance Corporation (FDIC) and is under $250,000, then your deposit is also insured. If the bank goes bankrupt, the FDIC will give your money back.
Why to Invest in CDs?
You've come to the correct place if a certificate of deposit sounds like something that could help you save money. The following are three main advantages of a CD:
- Flexibility: Brokered CDs are available in a variety of maturities, from 3 months to 20 years. This gives you the option of choosing between high levels of liquidity, which means you can reinvest your funds regularly, and stability, which means you can lock in attractive interest rates for a long time. CDs having longer periods or maturities, like other fixed income securities, provide greater yields.
- Safety: CDs are FDIC-insured up to $250,000 per account owner and per institution. There is, however, a technique to increase your coverage beyond this limit. While having the FDIC on your side is beneficial, CDs come with additional safeguards. One of the key advantages of a CD is that, unlike stocks, where significant quantities of money can be gained or lost in a single day of trading, money invested in a CD will increase consistently.
- Low Fees – Another advantage of a certificate of deposit is that it may have a very low fees. Some banks won't charge you a monthly fee if you keep your money in a CD.
While the lack of a monthly fee is an essential CD benefit, it's vital to keep in mind that a certificate of deposit may have other costs. Early withdrawal penalties and account fees are determined by the agreement in place at the time the account is opened, so be sure you read the fine print and understand what fees and penalties, if any, apply.
There is nothing as helpful as a good example.
Let's say, John has saved $5,000 which he does not need in the near future. Then, he decides to buy a CD at a 2.5% compounded interest rate. The term of the deposit is 2 years. If John withdraws money from his deposit account before the end of the second year, he will have to pay a penalty.
For the first year, John will receive $125 in interest (5,000×2.5%). For the second year, he will receive $128 (5,125×2.5%), and the whole amount of money after the maturity date will be $5,253.
How Is The Interest Rate Distributed?
It depends on the bank and the contract you have signed. There are CDs that offer the interest rate to be paid each month or once every three months. The money is deposited into the account. More often, banks pay the interest they owe the account holder when the term ends.
Sometimes, which is tricky, CD's rollover. This means that your contract is automatically renewed and your CD extends for a new term. The interest rate changes, however, and usually equals the current market one. If this is the case, end the contract on the day it expires and open a new one at better terms.
My advice is to know very well what kind of CD is your deposit account and all the details concerning penalties, interest rate, term, rollover, etc.
When to Consider CDs?
There are typically three primary situations where a CD works the best.
If you are looking to build short-term wealth, you could consider using CDs. These investments maintain a stable value, and you can use the funds in invest in CDs with a maturity of 6 months to 2 years.
You can also use CDs to lock up savings before a big purchase. If you are planning to buy a home in one year, you can lock up the money in a CD to earn interest before you are ready for the big purchase. A CD is relatively safe, and your money will be safe even if there is a stock market crash.
Finally, a CD is a good investment to earn returns without market risk. If you are wary of stock market risks, a CD acts as a good buffer against adverse market conditions in the short-term.
Which Banks Offer CDs?
Although most CDs are acquired directly from banks, CDs are also available from brokerage firms and independent salesmen. By pledging to deliver a particular quantity of deposits to the institution, these individuals and entities known as “deposit brokers” can occasionally negotiate a higher rate of interest for a CD. These “brokered CDs” can then be sold to customers by the deposit broker.
To guarantee that the CD is from a respectable institution, thoroughly research the issuer or deposit broker's background. Deposit brokers are unlicensed and uncertified, and they are not approved by any state or federal government. Because anybody can claim to be a deposit broker, always check to see if the deposit broker or the organization for which he or she works has a history of customer complaints or fraud.
Many deposit brokers have ties to financial advisors. The SEC and FINRA have internet databases where you may look up their disciplinary history. More information may be available from your state's securities authority. Start by calling the consumer protection office in your state to learn more about deposit brokers who are not linked with an investing business.
CD laddering is a very common strategy.
The deposit owner benefits from high-interest rates usually typical for long-term CD and has access at the same time to his funds. Simply said, you get high rates without “locking” your money for 3, 5 or more years.
The process of laddering includes buying several CDs with different terms. Instead of having one which rolls over at the end of the set period, you can have several deposits.
For instance: Let's take a look at John again. He has $5,000 extra cash, but he's not sure if he won't be needing this money in a year or two. Therefore, he uses the above-mentioned technique. He opens 5 CDs and invests $1,000 in each one of them. The first one has a year maturity, the second – a two-year term. The third has three-, the fourth four- and the fifth five-year terms respectively.
After the first CD expires, John opens a new five-year deposit. Then, next year his second deposit expires and he buys a new five-year deposit. In this way he ensures that each year he has a deposit that matures, taking advantage of the higher interest rates.
Can You Lose Money in a CD Account?
Generally, it is impossible to lose money in your CD account. Like any banking deposit, your bank or credit union is insured by the Federal Deposit Insurance Corporation (FDIC).
This means, in the event of bankruptcy, you can recover your investment to a tune of $250,000. Even if you decide to liquidate your CD before maturity, you typically don’t lose its value. However, if there is breach of contract, the institution of deposit may subject your withdrawal to penalties.
Disadvantages And Risks Related To CD
Early Withdrawal Penalty
As we mentioned, CDs have a preliminary set framework – term and interest rate. Unlike money market account, in case you should you withdraw money before the term ends, this might cause a penalty. The amount of this penalty depends on the money you have withdrawn as well as the deposit and the bank.
Usually, the institution that issues the deposit charges several months' worth interest. For instance, a 12-month CD's penalty might be three months of the annual interest on the money.
Keep in mind: Sometimes there is a Grace period during which early withdrawals are not sanctioned.
Ultimately, this is the greatest risk to CDs. Why?
This is particularly risky when you have a Traditional CD with a fixed rate and early withdrawal penalty. Let's imagine the interest you earn is 2% on the amount of money. However, this same year inflation rises by 2%. This means that you have not made any profit whatsoever. Sometimes the interest rate could be even lower (they have been pretty low recently, close to 1%) than the rate of inflation.
If a bank goes bankrupt, this is not a great day for deposit holders. Yes, the FDIC insures most deposits; it depends on the CD issuers as well as the amount of money. As previously mentioned, the FDIC covers only deposits up to $250,000.
Types of CDs
This is the most common type of CD. Its characteristics are:
- Fixed term (3 months, 6 months, a year, etc.)
- Fixed interest rate (for example, 1.5%)
- If you withdraw before the maturity ends – you have to pay a penalty.
- Protection by the FDIC if the deposit does not exceed $250,000
Stockbrokers and financial institutions may also offer deposits and they are called “brokered”. Actually, they represent a bank's offers, including those of online banking institutions. As a rule, brokered CDs are high-return, riskier and with a longer term.
In addition, not all of them are FDIC insured and might require a fee when purchasing the account. Moreover, sometimes there is a minimum limit of, for example, $10,000 to open an account.
CDs which do not offer a fixed interest rate are called variable- or flexible-rate CDs.
These usually carry a higher risk and a potential for greater returns. Normally, a person would buy a variable-rate CD with a longer term. There is an option of “bumping-up” which allows the account holder to adjust the interest rate according to market conditions. It's important to know how many times you can “bump-up” and when. Be sure to know all details, including when the interest is distributed.
I recommend this type to people who know the market very well. This is important because a person should know when exactly to adjust the interest rate and benefit the most.
Liquid CDs are deposits which allow the account holder to pull out some of the money without paying a penalty.
In order to take out money without an early distribution penalty, however, you have to follow some withdrawal limits. For this reason, these CDs offer lower interest rates.
The typical thing about this type is that it does not pay interest annually but rather distributes the amount after the end of the term. Banks offer zero-coupon CDs at great discounts, but you will have to pay taxes on the income. These CDs tend to offer higher rates.
Usually, brokers offer these types of CDs. The specific thing is that they contain a call feature.
What is that?
If the deposit has a term of 3 years, the bank might decide to end the contract prior to expiration.
Of course, there is a protection period, for example 6 months. If the bank does that, they have to pay the owner his money as well as the interest earned during the period.
Is A CD For You?
If you are wondering whether to open a CD, you should consider the following:
- Are you going to need the money in the near future? Remember, a CD “locks” your money for a preliminary set period of time.
- Do you want to invest short-term or you have plans in the long-run?
- Do you prefer lower returns and lower risk or you want to make a higher profit for a shorter period of time?
- Are you aware of the potential risks that deposits carry?
Answer these questions and then decide your next steps!
With the nation-wide rollout of the Covid-19 vaccination, the economy has been on a slow recovery, and the CD rates have been promising to up.
However, it will be a gradual process before the ultimate full recovery. In 2020-21, CD rates had plummeted to near zero as the economy absorbed the pandemic shock. With the Federal Reserve emergencies cutting on the rates in the bid to stimulate the economy, banks and credit unions also lowered CDs rates, and they are still reluctant to take in more deposits.
In case of a market crash, CDs are among the safest types of investment. Your CD investments will not have the same level of shock as shares of stocks held in publicly-traded companies. CDs offer a reliable yield, and are a viable option for investors looking to diversify away from the stock market or other volatile alternatives. Typically, CDs are fixed deposits in an account with a guarantee of some fixed interest rate return.
More often, during difficult economic times, banks reduce interest rates on CDs, and become reluctant to take in deposits because of future uncertainties. These measures combined with Federal Reserve emergency rates cuts motivate banks and creditors to push their CDs rates even lower. In some extreme cases, the CD rates can fall to near-zero, 0 – 0.2%.
Investing in CDs has one catch. Once you deposit your money, you cannot touch it before maturity. It works partly like a savings account, since you deposit your money and earn some interest over time.
However, when it comes to a CD account, you are entitled to receive a higher interest rate than your saving account. In addition, CDs accounts offer different terms bundled in 3-months, 6-months, 1-year, and 2-years in that order. The terms period depends on your goal. However, if you wish to terminate your CD before maturity, your withdrawal will be subject to a penalty.
If you request an early withdrawal before your CD matures, you will incur a penalty. The proportion of the penalty will depend on the withdrawal time relative to the maturity date. Though the penalty varies depending on the terms, most institutions calculate it from the interest the CD will make till maturity. Meaning, if you withdraw early, you’ll receive a higher penalty. The vice versa holds.
Also, shorter-term CDs attract a lower penalty compared to longer-term CDs. Besides, a big penalty could eat into your principal amount. You can still opt into a no-penalty CD that does not eat into your principal, but has a low APY.
Certificates of deposit are FDIC-insured up to $250,000 per individual account. That means your investment with your institution of the deposit is safe in case of any eventuality. However, there are situations when the FDIC does not cover your CD.
For example, if you decide to withdraw funds before maturity, you will incur penalties, which may even eat into your principal amount. Also, if a financial crisis such as a market crash occurs, some financial institutions may reduce CD rates due to the prevailing market conditions. The amount you’ll lose due to the reduced rates is not covered by the FDIC insurance.