You've likely seen ads from financial institutions touting the interest rates of their certificates of deposits (CDs), all competing for your savings. CDs offer safe, predictable returns at higher interest rates than you can receive from a savings account. Like savings accounts, the Federal Deposit Insurance Corporation (FDIC) insures CDs, with the balance of your CD accounts counting toward your total insured amount. Credit unions also offer CDs, which are insured by the National Credit Union Share Insurance Fund (NCUSIF).
CDs are time deposits that the bank accepts for a fixed term, usually three, six or 12 months, or up to five years. At the end of the term, you can cash in your CD for the principal and the interest you've made or roll the CD balance over into a new CD of any duration you'd like.
You must tell the bank what you've decided to do before the CD matures. Otherwise, the bank likely will automatically roll over your CD into a new one with the same term, but at the current interest rate. Banks usually will send you a notice before your CD matures asking what you'd like to do. Consider your options when rolling over—you might find a better interest rate with a CD that has a different term, or one from another bank.
CDs are less liquid than a savings account. You must deposit the full amount when you buy the CD and can't add or withdraw funds during their fixed term. And you'll be penalized if you cash in your CD before it matures, typically by forfeiting some of the interest you've earned. Banks usually pay higher interest rates on CDs than on savings or money market accounts as an incentive for you to give up some liquidity. The highest rates are generally for the longest-term CDs, though there are some exceptions.
Historically, every CD had a fixed interest rate over its term. But today you can find CDs with variable rates, sometimes called market-rate CDs. Their interest rates rise or fall as market rates change over the CD's term. These CDs let you take advantage of changes in interest rates. If you buy a variable-rate CD when rates are low, as they are today, you won't miss out on earning more interest if rates go up. On the other hand, if you think rates will fall in the future, then it might make more sense to buy a fixed-rate CD to lock in a higher rate over its term.
Climb the CD Ladder
A CD ladder is another way to generate a nice CD yield without locking up your money long-term causing you to miss rate increases during the term of a long CD. A ladder can help you take advantage of rising interest rates. All you need to do is divide the amount you plan to invest into equal amounts and buy the corresponding number of CDs with different terms maturing in sequence. If you start out with four CDs maturing in three, six, nine and 12 months, you replace the one maturing with a one-year CD, so you have an amount to cash in or reinvest on a regular schedule. You can create a longer-term ladder with CDs that mature on an annual basis to avoid locking in a low rate for a large amount of money. And you're not limited to using just one bank for a CD ladder. You can spread out your CDs over different banks, giving you the opportunity to pick the most advantageous rates.
Not all CDs are alike. Stockbrokers or other investment professionals also sell CDs, serving as a deposit broker for the banks that issue them. Brokered CDs may have a longer term than a CD you buy directly from a bank or credit union. However, they can be more complex and may carry more risk. Although most brokered CDs are bank products, some are designed as securities and are not FDIC or NCUSIF insured.
Also, you might have to pay a fee to buy a brokered CD, which could be a fixed amount or a percentage of the amount you invest. But if the fee is modest and the CD pays a higher rate than one you find at a bank, you may come out ahead. Many brokered CDs require a larger minimum amount to invest, as high as $10,000 or more.
Questions to Ask About CDs
Here are five key questions to ask, before you buy a CD:
1. What's the interest rate the CD pays and its annual percentage yield (APY)?
2. Is the rate fixed or variable, and if it's variable, what triggers a rate adjustment and when does it occur?
3. When does the CD mature?
4. What's the penalty for early withdrawal and are there exceptions to any penalties?
5. Is the bank or credit union issuing the CD insured by the FDIC or NCUSIF?
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