This tutorial will answer the following questions:
Certificate of Deposit (CD)
A Certificate of Deposit (CD) is a special kind of deposit account with a thrift institution or a bank that usually offers a higher interest rate than a normal savings account.
Purchasing a CD means investing a fixed amount of money for fixed durations ranging from six months to five years or more. In return, the issuing bank pays you interest, usually at regular intervals. When you redeem or cash in your CD, you are given the money originally invested, with any accumulated interest. If you happen to redeem your CD before maturation, you might have to forego a portion of the interest earned or pay an ‘early withdrawal’ penalty.
Although most people purchase CDs solely from banks, many independent salespeople and brokerage firms also offer CDs. These entities and individuals, also known as ‘deposit brokers’, can at times negotiate for a higher interest rate for CDs by guaranteeing the institution a certain number of deposits. The deposit broker then offers their customers these ‘brokered CDs’.
CD investors may choose between long-term CDs, variable rate CDs and CDs with other unique features. Some high-yield, long-term CDs have ‘call’ features, which means that the issuing bank might choose to terminate (call) the CD after some fixed period of time. A CD may be called only by the issuing bank, not the investor. For instance, if interest rates fall, a bank could decide to call all its high-yield CDs. However, if you have invested in a long term CD and the interest rates rise later, you will be stuck at the lower rate.
How to select an appropriate CD
Think through your financial goals
Before deciding to invest, sit down and honestly observe your entire financial circumstances, especially if you have not been making financial plans. The first step is to figure out your risk tolerance and your goals, either by yourself or with the assistance of a financial expert.
Establish when the CD matures
This may sound obvious, but many people fail to confirm their CD’s maturity dates, and are later surprised when they realize their money is tied up for up to twenty years. Before purchasing a CD, ask to be shown the maturity date on paper.
Examine any call features
Your ability to stick with a good interest rate in the long term is limited with a callable CD. With callable CDs, banks have the right to terminate the CD after a particular period of time. If interest rates drop, the issuing bank may call the CD. In such a situation, you should get the full amount of the original deposit, with any unpaid accumulated interest.
Confirm interest rate and method of payment
You should be given a disclosure document that outlines your CD’s interest rate and whether the rate is variable or fixed. In addition, ask how frequently the bank pays interest (for instance, monthly or bi-annually) and confirm the mode of payment (for instance, by electronic funds transfer or by check).
Ask if the interest rate might change
If you are thinking of investing in a variable rate CD, ensure you understand how and when the rate can change. Particular variable rate CDs have a ‘bonus rate’ or ‘multi-step’ structure where interest rates decrease or increase over time according to a pre-determined program. Other variable rate CDs have interest rates that vary according to performance of a specific market index, such as the Dow Jones or the S&P 500.
Investigate early withdrawal penalties
Make sure you find out what payments would be due in case you cashed in your CD prematurely.
Money Market Accounts
A Money Market Account (MMA) is a high interest savings account, or a premium account. However, a Money Market Account should not be confused with a Money Market Fund. The latter is an investment strategy with higher returns than a premium savings account. A MMA is very simple to open at any bank. The money kept in such accounts will be invested, but the financial institution is responsible for investing and collecting the returns. Your money is normally put into investments like Treasury Bills, Certificates of Deposit (CDs), or any other safe financial instruments. All these are short term, low risk investments. In return for your investment, the financial institution issues a premium interest rate, one that could be twice as high as a normal account.
Whereas a MMA is a decent low risk investment, remember that being an investment, it has certain limitations. Your money will not be as accessible as a normal savings account, and a MMA generally requires a minimum deposit and a minimum balance. Though you can make withdrawals from a MMA, there is a limit to how much you can withdraw each month. If you go below the required minimum balance, there will be a penalty.
How to choose between CDs and Money Market Accounts
As investment opportunities, both CDs and money market accounts have important advantages and disadvantages. However, your individual needs will determine which kind of investments account suits you best. Establish your individual needs and then compare the two to establish which the right kind of investment opportunity for you. The following are guidelines you can follow in making your decision.
When you want to know exactly how much your money will earn you, CDs are the best choice. Because they are fixed for a particular period, the earnings can easily be calculated. Money market accounts function more as a savings account or backup checking. This means money is easily withdrawn and deposited, which makes it hard to establish exactly how much you will make from your money.
Money market accounts are always opened for unlimited time spans. They are great for investing emergency funds or periodic funds like college tuition fees. On the other hand, CDs will lock your money in for a particular period of time. The usual CD time deposit ranges from 6 months to 5 years.
Whereas many money market accounts have limitations on the number of transactions that can happen each month, you will always have access to your money. With CDs, withdrawing money before maturity may lead to a penalty or loss of a percentage of your interest.