If you're thinking about stepping up your investment portfolio and want something reasonably low-risk with good return, the certificate of deposit (CD) market may be for you. There are many hues to this rainbow, however, and not all lead to an inevitable pot of gold. Certificates of deposit come in an assortment of denominations, maturities and risk profiles. You'll need to research your options and shop competitively to find one that matches your financial goals and risk tolerance. Be sure you understand the terms before you hand over your deposit -- once you've locked in your CD, it's there for the duration and you'll incur steep fees for early withdrawal.
Know the types of CDs. While there are many variations, there are four main categories you'll find CDs fall into -- conventional, jumbo, callable and variable. For first-timers getting into the CD market, a conventional CD offers the lowest-risk investment. Your deposit will earn a fixed-interest rate that does not change over the course of your investment. That means if you purchase a $1,000 5-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 gain at the end of the term. Jumbo CDs may sound silly in name, but with deposits required in the $100,000 or more range, they're definitely for the more wealthy investor. Brokered or callable CDs tend to be a higher-risk investment because they can be "called," or redeemed, by the bank for the full amount before they mature. Variable, or step-up, rate CDs offer you the ability to adjust your rate of return in the middle of the term you purchased.
Shop around for rates and terms. A general principal of CDs is that the more you invest, the larger the interest rate paid by the bank. However, market forces are what drive interest rates, so this may not always be the case. Terms of CDs generally range from six months to five years, but some offer periods as long as 10 to 20 years. While many people purchase CDs from their banks, it's a good idea to shop around for the best rates. Many brokerage firms offer CDs with more competitive rates because they buy CDs in bulk from banks and then sell them off. CDs feature federal deposit insurance (FDIC) up to $250,000; however, be sure to fully understand terms and conditions of your CD before purchasing. If you're a high-roller in jumbo CDs and don't invest wisely, you could quickly max out your insurance safety net.
Understand special features of your CD. If buying through a broker, find out which bank issued your CD so that you can ensure your FDIC protection rights. Be sure to get documentation, including the maturity date of the CD. Find out the callable date, too, if applicable. Even though your CD may have a five-year maturity date, the bank may have a call date of six months. Depending on what interest rates are at the call date, the bank can opt to return your money with interest earned or leave your CD alone -- until the next call date, when the process repeats. For example, if interest rates have dropped since the bank issued your callable CD, they may opt to borrow money elsewhere at that reduced rate. Don't worry, you'll get your principal with interest returned to you; however, that leaves you having to find another investment option for your money -- now at a lower interest rate. Varying rate CDs also offer a higher degree of risk. You will likely come in at a lower interest rate, hedging your bet that interest rates will turn in your favor and you'll be able to take advantage of a higher rate down the line. For example, if you buy a two-year CD at a given rate and six months into the term the bank increases its rate by a quarter percent, you can step up your rate to that amount. 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.
Know the penalties for early withdrawal. When buying a CD, it's easy to get caught up in thinking about all the interest your money will earn while it's safely deposited away. But pay attention to the rest of the terms outlined. One of the key points of CDs is that you are not to access your money, or cash out, until the term comes due. Be prepared to pay a penalty for early withdrawal. Federal law requires a minimum of seven days' interest for early withdrawal on a CD; however, since there is no maximum set, banks can charge more. According to Bankrate.com, it is common for banks to charge as much as six months' interest on a two-year CD cashed out early.
- Some people "ladder" their purchases of CDs by purchasing several at fixed-rates that mature at different dates. For example, you can buy one CD that matures in six months, another in a year, and another in five years. As interest rates rise, you can re-invest the proceeds at a higher rate. If they fall, you will be able to ride out the market with your longer-term CDs.
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