The ultimate financial investment for most people consists of an instrument that yields a high rate of return on their money with little or no risk of principal. Most certificates of deposit do not offer high yields, but CDs have a higher rate of return in comparison to bank savings accounts or money market accounts. In addition, many people invest in CDs because of the low-risk nature of the instruments, which allow them to sleep better at night.
Certificates of deposit works in the following way: An investor usually buys a CD from a bank or some other financial institution. He or she decides to invest a fixed sum of money, which goes into a deposit account for a fixed period—called the “maturity.” The choice of maturity consists of short-term and long-term durations. Short-term maturity begins at three months and go up to one year. Long-term maturity options may exceed five years.
In exchange for purchasing the CD, the institution pays you a bank CD 2 to 3 percent interest at predefined intervals. If you decide you want your money back before the CD reaches maturity, you must pay a substantial penalty. The penalty may equate to as much as six months’ interest payment.
Where to Buy CDs
Traditionally, most investors purchased CDs from their local banks or thrifts where they have accounts. Today, stock brokerage firms and “deposit brokers” offer CDs. Deposit brokers, who specialize in selling certificates of deposit to the general public, pledge to deliver a specific number of CD investors to an institution. In return, deposit brokers may negotiate higher certificates of deposit rates. Higher CD rates make the instruments more enticing to their customers.
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In the past, most CDs paid investors a fixed rate of interest up to the instrument’s maturity. However, CDs have gone the route of many other investment products sold in today’s markets and have become more sophisticated. Many institutions sell CDs that offer investors variable rates of interest, longer maturities, and higher yields. Some CD issuers even offer certificates of deposit with special redemption elements should the CD purchaser dies.
Investors who choose to purchase long-term, high yield CDs should understand that the issuing bank might have a “call” feature written into the agreement. This means the bank can end the investment agreement – or call – the CD after a specified period, such as one year. The ability to call high-yield CDs protects institutions in times of falling interest rates.
Typically, an investor cannot call a CD. Therefore, if you lock yourself into a long-term, high-yield CD and the interest rates rise, you cannot take advantage of the higher interest rates unless you pay a hefty penalty for withdrawing the funds before maturity.
CD Investment Strategies
Divide the money your CD investment fund between short-term and long-term maturities. Simply decide on what percentage of your money you will allot to high yield CDs. Invest the remainder of your money in short-term CDs. The primary benefit of the barbell strategy lies in the “liquidity” you have to take advantage of rising interest rates.
This technique calls for the investor to focus on investing his or her money in one maturity. For example, choose a fixed period of one year, but spread out the CD purchases. This strategy minimizes the risk of buying all of your certificates of deposit during a period of low interest rates. Employ this investment technique when you want to save money for a specific objective, such as a college education fund, a down payment on a home, or a new vehicle purchase.
Usually, the Federal Deposit Insurance Corporation (FDIC) insures bank deposit accounts up to $250,000 at a single institution. Individuals who have more than $250,000 to invest in CDs may want to consider The Certificate of Deposit Account Registry Service (CDARS). CEDARS – operated by the Promontory Interfinancial Network—allow member banks to offer individual CD investors millions of dollars in FDIC coverage. This eliminates the need to open accounts at multiple institutions.
Decide on an investment strategy that fits your temperament and objectives. For example, you may have a higher comfort level purchasing a CD directly from your bank and with a maturity of one year or less versus other the other choices. In addition, shop around and compare CD rates before opening up a certificate of deposit account.
We intend this guide for informational purposes only. Confer with your financial advisor before making any investment decisions.