An average consumer may not know the attractive term, certificate of deposit (CD), as they generally consider them to be wealthy individuals’ investments. However, as an investor, you should know what a CD is and how it works.
A CD is usually a low minimum deposit and low-risk investment that ensures earned interest. To receive a substantial return, it requires a large capital of investment from you. That might be the reason average consumers avoid them.
A certificate of deposit is an investment product offered by financial institutions such as banks. A CD is a type of bank account that customers make a deposit and earn a certain level of interest for leaving their funds untouched for a given period and withdrawing the amount before maturity is penalized.
Almost all financial institutions offer CDs. The banks set the terms and interest rates for the CDs.
Being open to options from different banks is key to having the best CD investment. For instance, your local bank may offer a low interest rate with longer terms. Online banks or credit unions might have three to five times interest rates than your bank.
The financial institution has a disclosure statement on the CDs outlining the rate, whether it is fixed or variable, and when the financial institution pays interest, whether monthly, semi-annually, or annually.
The disclosure should state the maturity date, how investors receive their money, whether through check or electronic transfer, and any penalties on CDs withdrawn before the stated maturity date.
Like any other financial instrument, CDs have other risks such as a low-income rate that may be surpassed by the inflation growth rate. If inflation grows faster than the interest rate on your investment, your overall return will be minimal.
The process of opening a CD is similar to opening a standard deposit account. After comparing CD offers from different banks, you open a CD which will lock your deposit into:
The CD interest rate is the bank rate used to calculate how much return your deposit will yield at the maturity date.
After signing your CD, you lock your deposit at the given interest rate. The locked rate ensures the return on your deposit after the specified CD term. The bank cannot change the rate to increase or reduce your earnings.
On the other hand, a locked interest rate may be unfavorable if the interest rates rise during the specified period.
Consider the three different types of certificate of deposit interest-rates:
A fixed-rate CD – pays out a uniform interest rate throughout the CD term. A 5-year CD with 2.0% APY, for instance, earns interest at a constant rate regardless of a rise or fall in the interest rate during the CD period.
Variable-rate CD – has a fixed term and pays a percentage of interest regardless of the changes to the opening interest rate and the rate at the end of the CD term. For example, if you opened a 3-year CD at 1.06% and by the time the three years are ending, the rate is 1.16%, the institution will calculate your return based on the interest growth over the period. But the latter could also occur. A variable-rate CD follows the market changes. Regardless, you will always receive a return on your investment in the end.
Adjustable-rate CD – the institution will set the interest rate when you are opening a CD but will give you an option to adjust the rate during the period. You will, however, have a limited number of times to adjust the rate.
The term is the length of time that you agree to lock your deposit without making any changes or withdrawing funds. Withdrawing your deposit within this period incurs a penalty.
There are three ranges of CD terms:
The maturity date is when the term expires and signifies the earliest date to withdraw your money without being penalized.
The principal is the amount you agree to deposit after opening a CD. After signing, the principal is locked in, and you will not have access for the specified period without sustaining a penalty. There is no fixed amount the investor is required to deposit; it varies according to the investor and the financial institution of choice.
The institution is the bank or credit union you choose to open a CD with and determine the disclosures guiding the CD agreement. The disclosures include the interest rate, CD terms, penalties, and how the institution dispenses your funds after maturity.
It should also state whether the bank will automatically reinvest the funds if the investor does not instruct otherwise after maturity.
Every financial institution offers CDs or similar financial products. Banks’ deposit model is one version of a CD where they take deposits from individuals and use a portion to lend out to people borrowing loans.
The bank makes a profit by offering a small interest to deposits with them and charging higher interest on money lent out.
One risk the banks face is that investors can request to withdraw their money at any time, and the bank is obliged to return the amount. The bank may not have the full amount to refund because they have lent out some of the money but are required to reserve a certain ratio that has been invested. This is to ensure they can provide a refund to the investor.
A bank’s business model is different and risky in comparison to CDs, which have a fixed period, as mentioned earlier.
Generally, banks set their CD rates based on the Federal Reserve Board’s rate. The reason the banks determine their CD rate according to the Federal Reserve Board is that a financial institution’s costs are directly influenced by the decisions made by the Federal Reserve.
The Federal Open Market Committee (FOMC) is a group that decides every six to eight weeks whether to raise or lower the federal funds rate. The federal funds rate is interest paid by the banks to the Federal Reserve in order to borrow money.
When the federal funds rate is low, banks borrow from the Federal Reserve because it is cheaper to do so than to take deposits from investors. Banks will also lower the CD rates to make CDs less attractive to potential customers. But when the federal fund rate is high, they opt for the investors’ deposits and offer a competitive interest rate.
Apart from the Federal Reserve’s impact, financial institutions also consider their performance when setting CDs’ interest rates. For example, if a bank’s loan products are doing well, and they need to lend out money, the bank sets high-interest earnings on deposits to attract investors.
A local bank might also have a high-interest rate as they need more deposits. A large bank with a large capital base may have no motive to take deposits.
A certificate of deposit is the safest kind of investment. CDs offer fixed and federally insured interest rates which may be higher than those offered by bank accounts.
Compared to a brokerage account, you could lose your investment in stocks and bond markets. These markets are risky and unpredictable, and also require expert investment knowledge. Investing in CDs guarantees a return at the end of the period, even if it is a small growth in your finances. After signing on the deposit agreement, the return cannot fluctuate even with the changes in the market interest rate.
A CD deposit is also protected by the Federal Deposit Insurance Corporation (FDIC) for banks and the National Credit Union Administration (NCUA) for credit unions. The FDCI and NCUA provide insurance against bankruptcy for up to $250,000 of your deposit in an institution.
It is essential, when shopping around for an institution, to choose one insured by FDCI or NCUA. Also, avoid holding more than $250,000 with one institution. If you have more than that, it is advisable to spread your funds across several institutions to maximize the insurance.
» Explore your options here see a list of the best CD rates
Opening a certificate of deposit is useful in almost every situation. For instance, if you have excess money you do not plan on spending any time soon, you can open a CD for a fixed period until you require use of those funds.
On the other hand, a CD can be of great assistance if you have a hard time saving. The financial institution will penalize you if you withdraw your CD deposit earlier, giving you a reason to wait for maturity.
There are two primary considerations when choosing a CD term. The first consideration is what your plan is for your funds. For instance, if you have a project with a specific start date, then you can set your CD term to end when you are starting your project. If you have no specified plan for your money, then a longer-term with a higher interest rate will be the better option.
The second consideration is the fluctuation of the Federal Reserve’s rate. If it is anticipated that the rate will rise, financial institutions will likely offer better rates for your money.
Therefore, it is advisable to take short-term and mid-term CDs in order to take advantage of higher rates when the current CDs mature. On the other hand, if the Federal Reserve’s rate is expected to fall, you can lock your investment with the current higher interest rate.
A CD ladder is a way investors reduce the risk against changes in the interest rate during the CD term. It allows investors to enjoy higher rates in a 5-year CD term. However, only a small portion of the invested amount is available every year and not at the end of five years.
Suppose you had $50,000 to invest, it will be subdivided into five CD terms of $10,000 each as follows:
As your first CDs mature, the funds are reinvested in top-rate 5-year CDs as follows:
This way, you will have more access to your funds as compared to locking all your funds for five years.
Certificate of deposits is one of the safest financial products because the deposit is insured and the interest rate locked is free from fluctuations in the market. Due to the low CD interest rates, investors need to invest large capital and take longer terms to earn substantial returns.
CDs can secure money for important future spending, but you can access your funds by paying a penalty for early withdrawal in case of an emergency.
Every financial institution offers CD options. However, they have different terms and different interest rates that you must consider before opening a CD with any institution. Shop around for the best CD terms and rates to maximize gains from your investment.
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