Investing in Certificates of Deposit

If your savings grow to the point where you have more
money than you think you need anytime soon, congratulations!
One of the places you can consider depositing some of
the balance is a certificate of deposit (CD).

A CD is a receipt for a deposit of funds in a financial institution.
Like savings accounts and money market accounts,
CDs are investments for security.

With a CD, you agree to lend your money to the financial
institution for a number of months or years. You can’t touch
that money for the specified period of time without being
penalized.

Why would a financial institution need you to loan it money?

Typically, institutions use the deposits they take in to fund
loans or other investments. If an institution primarily issues
car loans, for example, it’s apt to pay attractive rates to lure
money to four-year or five-year CDs, the typical car-loan
term.

Generally, the longer you agree to lend your money, the
higher the interest rate you receive. The most popular CDs
are for six months, one year, two years, three years, four years,
or five years. There is no fee for opening a CD.

By depositing the money (a minimum of $500) for the specified
amount of time, the financial institution pays you a higher
rate of interest than if you put your money in a savings, checking,
or money market account that offers immediate access to
your money.

When your CD matures (
comes due), the institution
returns your deposit to you, plus interest.
The institution notifies you of your CD’s maturation by mail
and usually offers the option to roll the CD over into another
CD. When your CD matures, you can call your institution
to find out the current rates and roll the money into another
CD, or transfer your funds into another type of account.

Most institutions give you a grace period, ten days or so, to
decide what to do with your money when the CD matures.
At an FDIC-insured financial institution, your investment is
guaranteed to be there when the CD matures.

Financial advisors say that CDs make the most sense when
you know that you can invest your money for one year, after
which you’ll need the money for some purchase you expect
to make. The main reward of investing in CDs is that you
know for sure what your return will amount to and can plan
around it, because CD rates are usually set for the term of
the certificate.

Be sure to check on the interest rate terms,
though, because some institutions change their rate weekly.
For example, after buying a house in early fall, my friend
Mark made plans to have the exterior repainted the following
spring (a short-term goal). In October, he received a nice
$4,000 bonus from work. Knowing that he might be
tempted to spend that money on dinners and CDs (the musical
kind), Mark invested that $4,000 in a six-month certificate
of deposit with a 4.6% interest rate. When spring rolled
around, his CD matured, and he received $4,092. That
amount he gained in interest may not sound like a lot, but
it’s about twice as much as he would have received had he
deposited the money in a typical savings account. And it’s
possibly $92 more than he would have had if he had kept the
money in his regular, non-interest-bearing checking account.

The major risk is that interest rates can rise sharply before
your CD matures. That situation costs you the opportunity
to earn more on your money through some other form of
investment.

The interest rates paid on CDs are contingent on many factors.
In general, they tend to mirror the interest rates in the
general market. Most bank CDs are tied to the rates paid on
treasury notes and treasury bills. (Treasury rates are the rates
offered by the Federal Reserve when they issue treasury obligations.)
If the two-year treasury note pays a good rate, interest
rates on the bank’s CDs tend to be at a good rate, too.
It pays to shop around for CD specials to get the best interest
rate. Remember to check out the rates at savings and loans
and credit unions. Credit unions typically pay up to half of
a percentage point higher interest on CDs, whereas savings
and loans generally pay more than banks but less than credit
unions.
$3,980
$4,000
$4,020
$4,040
$4,060
$4,080
$5,000
$4,040.00
Savings
Account
$4, 092.00

If you want your money back before the end of the CD’s
term, you will be heavily penalized, usually with the loss of
six months’ worth of interest. A second drawback is that CDs
are taxable. Whatever interest you earn, you must pay taxes
on at both the federal and state levels. However, assuming
that you’re not in a high tax bracket, the taxes shouldn’t be a
huge consideration for most people starting out.

If rates are low, you may want to purchase shorter-term CDs
and wait for rates to rise. This way, you won’t be tying up
your funds for long periods of time while rates might be
climbing. As another option, some banks might allow you to
add money to a CD account at the interest rate of that particular
day. The advantage to this method is that if you open
the account on a day when the rate is low, you can increase
your earnings by adding money at a
higher rate, later.