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Certificates of deposit (CDs) are one of the most common financial instruments sold by banks and credit unions. They are different from savings accounts mainly because they have a specific fixed term during which they mature. They are determined by a fixed interest rate during that entire period. When the maturity is reached, the certificates of deposit can be withdrawn for interest payments.
Just the Nuggets
- Certificates of deposit have much lower risks than other financial instruments since you vow not to withdraw the funds before the predetermined maturity date.
- When opening a certificate of deposit, you should consider the conditions attached to it, including the term, the amount of deposit and the interest rates.
- There are a few types of certificates of deposit including liquid, bump-up, step-up, brokered, and jumbo.
- Over time, this area of investing has produced some beneficial strategies including the ladder, the structured CD, and the barbell strategies.
How Certificates of Deposit Work
Certificates of deposit are quite similar to savings accounts—mainly because they are insured, they’re virtually without any risk. In the United States, for example, certificates of deposit are insured by the Federal Deposit Insurance Corporation (FDIC) for banks and the National Credit Union Administration (NCUA) for credit unions.
The main feature of certificates of deposit is, they are issued by banks and credit unions in exchange for the client agreeing not to touch the lump-sum deposit for a predetermined period of time during which the certificates of deposit mature. When the maturity date comes, the holder is paid interest in exchange. It is important to note that the interest rates here are much higher and admirable, according to the commitment that clients make for the time being.
Certificates of deposit are available in all banks and financial institutions, although the terms may vary. For example, the interest rates are usually fixed, but they can also vary in some institutions. Back in 2004, the banks offered a certain bump in the interest rates in specific cases. Also, there are some financial institutions that offer the option of exiting early if you encounter some type of an emergency or change in plans.
Opening a Certificate of Deposit
The process of opening a certificate of deposit is quite similar to opening a standard bank account. However, there are a few things to consider before deciding on the right one, which will significantly improve your experience later down the line.
The interest rate is the main factor contributing to the amount of profit you’ll receive from your certificate of deposit. The fixed rates are usually the best option since they provide a clear insight into the future and the possibility of returns on your investment. However, you may miss out on significant profits in case the interest rates happen to rise in the future.
The term is a predetermined period of time during which you agree not to touch your funds to avoid penalty. This period ends with a maturity date, after which you can withdraw your funds without penalties or other strings attached. You’ll also have several options to choose from. Typically, the term may last for about six to 18 months. In case you do nothing and your certificate of deposit is set off automatic renewal, your deposit will be reinvested into another CD.
The principal is the amount of funds you are agreeing to deposit. This may vary from one financial institution to another, depending on the type of CD you like.
By choosing the financial institution to open your certificate of deposit, you are agreeing to the unique terms attached to your CD—anything from withdrawal penalties to the maturity date.
After deciding on these details, the bank or credit union of your choice will administer the certificate of deposit like other savings accounts. They’ll also provide you with a monthly or quarterly statement regarding your account, the payments, and other key features you should keep up with.
How Are Interest Rates Determined?
The interest rates are a part of a wider monetary policy determined by the country’s central bank or other equally relevant government institution. For example, the key authority in this area is the Federal Reserve. The Fed holds regular meetings with its members where they decide on many features and contributors to the country’s economic policies, and that includes the interest rates.
In the case of certificates of deposit, things are a bit different from other areas of finance. Here, the Federal Open Market Committee (FOMC) is the key authority that revises the decision on interest rates every 6 to 8 weeks. For example, the FOMC made its most drastic decision regarding interest rates back in 2008, when they decided to bring them to their lowest level due to the global financial crisis. The Fed only started to gradually raise them in 2015 in order to create a suitable and lasting balance.
Why Should You Open a Certificate of Deposit?
As mentioned, the main advantages of CDs are the little to no risks attached to them since deposits are federally or otherwise insured by the country and its central bank (or other government institution) and the higher interest rates than with other bank accounts since you agree not to touch your deposit for a long period of time. Certificates of deposit are especially appealing to clients who wish to earn more through savings, without taking on any risks that the market brings.
Are Certificates of Deposit Safe?
Certificates of deposit are considered as one of the safest financial instruments because of the fixed interest rates, which take away a lot of the risk typically attached to other instruments. They are also insured by a key government or other financial institution, so there is no fear of losing your deposit in case the economy in the country tumbles for any reason.
However, there are some institutions that were able to slip through the cracks and provide CDs despite not being regulated by a respected institution in their area. This is why it is important to do your research and make sure that the institution is insured and satisfies all the standards of the industry.
Types of CDs
Aside from the standard CD types available in most financial institutions, there are a few other important ones to mention. Each one comes with a specific set of rules and requirements for the clients when it comes to the amount, term, and other key features of this financial instrument.
Liquid (No Penalty)
This type of CD appeals to the clients because it allows them to withdraw funds without paying a penalty. However, it pays much lower interest rates than other types. Still, many clients choose this option because of its flexibility—it gives the opportunity to move funds to a higher-paying CD in case the opportunity comes up.
This type is quite similar to the previous one. It gives you a lot of benefits, the main one being that you can switch to a higher interest rate account if the opportunity arises. However, the downside here is evident when the rates stagnate or begin to drop. In this case, the clients are better off with a standard CD.
The step-up CD does not tie you to the interest rate level you started off with when you opened your account. It actually allows you to enjoy the increased interest rates, typically after six or seven months.
Brokered CDs are a bit riskier than the previous types mentioned, mainly because they are tied to broker companies which work with a variety of assets—from stocks and commodities to currencies. However, they also give a lot more options than other types of CDs.
Lastly, the jumbo CDs have a quite high minimum balance requirement, typically as high as $100,000. This is still not a lot in the US, considering that the FDIC insures up to $250,000 on all accounts.
Pros and Cons
Certificates of deposit are beneficial in many situations. Similar to savings accounts, CDs are a useful tool that will help you save a significant amount of money over time—thanks to the appealing interest rates you usually won’t find in other financial instruments.
What are some other advantages of opening a certificate of deposit?
1. The funds are insured
In the United States, the funds you deposit on your CD are insured by the FDIC up to $250,000. This is the main reason why so many clients choose it instead of bonds, stocks, or other highly volatile financial instruments.
2. Admirable interest rates
Considering that you vow not to touch the deposited funds during a significant period of time, the banks and credit unions usually reward you with more appealing interest rates than you would normally get with other accounts.
3. Fighting off the temptation
Maybe the most attractive benefit of CDs is, they help the high spenders resist the temptation. With CDs, you are obligated to respect the entire term and only collect your funds after the maturity date.
What about the downsides? The main downside of CDs is also a benefit since you’re not able to withdraw your money beforehand.
1. Withdrawal penalties
The main requirement of CDs is for you to not withdraw the money you deposited regardless of the circumstance. On that note, you will have to pay a significant amount in penalties in case you decide to do so after all.
2. Smaller earnings
Despite the appealing interest rates unavailable in any other accounts or financial instruments, CDs still earn significantly less profit in comparison to stocks and bonds.
3. Fixed interest rates
Though the interest rates attached to CDs are quite beneficial, they are fixed in most cases. This means that you cannot acquire additional profits, which you’d be able to do if you adjusted your account to a rising interest rate.
Investing Strategies for CDs
There are many ways to create a solid and successful investing strategy for your certificate of deposit. They mostly consist of the things you can do to benefit your position and ensure the return on your investment, such as finding a suitable and regulated financial institution, deciding on the amount of deposit, the term, etc. However, there are also concrete strategies regarding your investment which you could apply here as well.
The Ladder Strategy
This strategy consists of opening multiple CDs with different maturing dates. Logically, this will spread your profits and raise your revenues since there are more opportunities for growth and earnings. It is especially useful when one of your certificates expire, so you have other ones to look forward to in the future.
The Structured CD Strategy
Structured CDs are typically attached to other beneficial financial instruments such as stocks, currencies, or commodities. The main benefit here is that your profits can increase based on the instrument they are attached to, considering that they draw earnings from their performance as well.
The Barbell Strategy
This is quite similar to the ladder strategy but is a lot simpler. It consists only of two levels—the short maturities and the long ones tied to the high-yield savings account. This makes the entire investment a lot more liquid than it would be with other strategies.
In the end, certificates of deposit have a lot more benefits compared to other financial instruments. They represent a useful way of acquiring profits over a long period of time, thanks to the appealing interest rates. However, the most important thing to make this a reality is the clients’ patience to not retrieve their funds before the maturity date.
Our References and Further Readings
- Pritchard, J. (2020, June 30). How Certificates of Deposit Work. Retrieved from https://www.thebalance.com/
- Karl, S. (2020, April 30). Certificates of Deposit. Retrieved from https://www.investopedia.com/
- Discover Bank, How to Open a Certificate of Deposit. Retrieved from https://www.discover.com/
- Goldberg, M. (2020, March 4). Top 18 Strategies for CD Savers. Retrieved from https://www.bankrate.com/