Purchasing a certificate of deposit, or CD, can be a relatively safe investment option as long as you pay attention to the terms -- and are willing to abide by them. While all CDs are backed by federal deposit insurance, some are more aggressive and may increase your investment risk. There are certain features of some CDs that don't make them a good investment choice for everyone. Maximize your success by selecting a CD that best matches your financial goals and risk tolerance.
Tend to be more of a teacup person than a Tilt-a-Whirl one? A conventional CD offers a fixed interest rate that does not change over the course of your investment. That means if you purchase a $1,000 five-year CD at 2.75 percent, you will know to the penny -- depending on how and when the interest is calculated -- how much you will have to spend at the end of the term. All CDs are FDIC-insured up to $250,000, and conventional CDs are among the lowest-risk investment options out there.
Flexible- or Variable-Rate CDs
These are for the more adventurous investors who can tolerate more risk, and who want a higher rate of return than most money markets. Interest rates can change during the term of variable-rate CDs. Unfortunately, as their name warrants, these CDs require investor flexibility, so the longer the term you can purchase them for, the better you'll be able to tolerate the highs and lows of the market and come out ahead. Many variable CDs have a "step-up" or "bump-up" structure that allows you to adjust your rate of return in the middle of the term you purchased. Be sure to understand how your interest rate is structured, including how often you can bump up the rate, and how the bank pays interest during the term. To maximize your returns in this type of investment, you'll need a decent understanding of interest rate conditions so you'll know when to optimally "bump" your investment.
If you've got a little more wiggle room in your investment risk, callable CDs can seem exciting with their attractive interest rates and roll-with-the-dice structure. However, be sure to understand the terms before you leap ahead; many callable CDs tend to be for longer periods of five, 10 or 20 years. Be sure not to confuse a CD's callable date with its maturity date. A six-month callable CD could have a five-year maturity date. Read the fine print. Callable CDs are similar to regular CDs in that they pay a fixed interest rate over their lifetime. However, to make things more interesting, these CDs allow the bank or brokerage firm to "call," or redeem, your CD for the full amount before maturity. How could this possibly be a good thing for me, you're wondering? Let's say you have a 15-year maturity CD at a 4 percent fixed rate with a one-year call date. At the call date, interest rates are now up to 4.75 percent. Don't get too excited, nothing changes for you; you're locked in, remember? But the bank sees things a bit differently. Your investment looks even better to the bank because it's borrowing money from you at 4 percent -- less than the current market rate. However, should interest rates fall below 4 percent at that one-year call date, the bank may opt to redeem your CD and borrow money for less elsewhere than it's paying you. That leaves you having to find another investment option for your money -- now with a lower interest rate than you were locked in at! To make them more attractive to buyers, many callable CDs come with an initial "noncallable" introductory period where they cannot be redeemed. During this time, the bank tends to pay a slightly higher interest rate than you can get from conventional CDs. Callable CDs are also offered with other rate structures for more diversified investment growth -- and risk. Bottom line: With a callable CD, the bank or brokerage firm not only holds the cards, but it is the only one that can call the hand. The issuer can take your perfectly nice fixed-rate earnings CD and return it to you -- the principal with interest earned thank-you-very-much -- if they can get a better deal somewhere else at the call date.
Early Withdrawal Penalties
Taking your money out early from a CD can be costly. Penalties vary depending on the type of CD purchased and where you purchased from -- a bank or broker. While federal law mandates a minimum seven days' interest for early withdrawal, banks typically charge that plus more depending on the maturity date of your CD. For example, a survey of online banks indicates withdrawal penalties for CDs with terms less than one year typically charge a penalty of 60 to 90 days interest. Penalties for CDs with two-year terms or longer could range from six months to a year's worth of interest if cashed out early. Bank of America offers a nine-month term "Risk Free CD," which permits you to access your money prior to the maturity date without incurring penalties. It requires a steeper deposit minimum of $5,000. Brokered CDs may or may not allow for early withdrawal privileges. Some brokers may be willing to purchase or resell your CD prior to maturity. Be sure to check the terms and conditions before purchasing any type of CD.
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