Investors searching for relatively low-risk investments that can easily
be converted into cash often turn to certificates of deposit (CDs). A
CD is a special type of deposit account with a bank or thrift
institution that typically offers a higher rate of interest than a
regular savings account. Unlike other investments, CDs feature federal
deposit insurance up to $250,000.
Here’s how CDs work: When you purchase a CD, you invest a fixed sum of
money for fixed period of time: six months, one year, five
years, or
more and, in exchange, the issuing bank pays you interest,
typically
at regular intervals. When you cash in or redeem your CD, you receive
the money you originally invested plus any accrued interest. But if you
redeem your CD before it matures, you may have to pay an "early
withdrawal" penalty or forfeit a portion of the interest you earned.
Although most investors have traditionally purchased CDs through local
banks, many brokerage firms now offer CDs. These brokerage firms, known
as "deposit brokers" , can sometimes negotiate a higher rate of
interest for a CD by promising to bring a certain amount of deposits to
the institution. The deposit broker can then offer these "brokered CDs"
to their customers.
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At one time, most CDs paid a fixed interest rate until they reached
maturity. But, like many other products in today’s markets, CDs have
become more complicated. Investors may now choose among variable rate
CDs, long-term CDs, and CDs with special redemption features in the
event the owner dies.
Some long-term, high-yield CDs have "call" features,
meaning that the
issuing bank may choose to terminate or call the CD after only
one
year or some other fixed period of time. Only the issuing bank may call
a CD, not the investor. For example, a bank might decide to call its
high-yield CDs if interest rates fall. But if you’ve invested in a
long-term CD and interest rates subsequently rise, you’ll be locked in
at the lower rate
Before you consider purchasing a CD from your bank or brokerage firm,
make sure you fully understand all of its terms. Carefully read the
disclosure statements, including any fine print. And don’t be dazzled
by high yields. Ask questions and demand answers before you
invest.
These tips can help you assess what features make sense for you:
Find Out When the CD Matures. As simple as
this sounds, many investors
fail to confirm the maturity dates for their CDs and are later shocked
to learn that they’ve tied up their money for five, ten, or even twenty
years. Before you purchase a CD, ask to see the maturity date in
writing.
For Brokered CDs, Identify the Issuer. Federal
deposit
insurance is limited to a total aggregate amount of $250,000 for each
depositor in each bank or thrift institution, it is very important that
you know which bank or thrift issued your CD. In other words, find out
where the deposit broker plans to deposit your money. Also be sure to
ask what record-keeping procedures the deposit broker has in place to
assure your CD will have federal deposit insurance. For more
information about federal deposit insurance, call the FDIC's
Central Call
Center at (877) 275-3342 or (877) ASK-FDIC. For the hearing impaired
call 1-800-925-4618 or 1-703-562-2289 (7:00 am to 7:00 pm Eastern time)
Investigate Any Call Features. Callable CDs give the
issuing bank the
right to terminate the CD after a set period of time, but they do not
give you that same right. If the bank calls or redeems your CD, you
should receive the full amount of your original deposit plus any unpaid
accrued interest.
Understand the Difference Between Call Features and Maturity.
Don’t
assume that a "federally insured one-year non-callable" CD matures in
one year. If you have any doubt, ask the sales representative at your
bank or brokerage firm to explain the CD’s call features and to confirm
when it matures.
Confirm the Interest Rate You’ll Receive and How You’ll Be Paid.
You
should receive a disclosure document that tells you the interest rate
on your CD and whether the rate is fixed or variable. Be sure to ask
how often the bank pays interest. (for example, monthly or
semi-annually) And confirm how you’ll be paid. (for example, by
check
or by an electronic transfer of funds)
Ask Whether the Interest Rate Ever Changes. If you’re considering
investing in a variable-rate CD, make sure you understand when and how
the rate can change. Some variable-rate CDs feature a "multi-step" or
"bonus rate" structure in which interest rates increase or decrease
over time according to a pre-set schedule. Other variable-rate CDs pay
interest rates that track the performance of a specified market index,
such as the S &P 500 or the Dow Jones Industrial Average.
Research Any Penalties for Early Withdrawal. Be sure to find out
how
much you’ll have to pay if you cash in your CD before maturity. Shop
around - find the CD and the terms which best suit your needs.
Ask Whether Your Broker Can Sell Your CD. Some brokered CDs
are issued
in the name of the "custodian" or deposit brokers. In some cases, the
deposit broker may advertise that the CD does not have a prepayment
penalty for early withdrawal. In those cases, the deposit broker will
instead try to resell the CD for you if you want to redeem it before
maturity. If interest rates have fallen since you purchased your CD and
demand is high, you may be able to sell the CD for a profit. But if
interest rates have risen, there may be less demand for your
lower-yielding CD. That means you may have to sell the CD at a discount
and lose some of your original deposit .
Find Out About Any Additional Features. For example, some
CDs offer a
death benefit that allows a CD owner’s heirs to redeem the CD without
penalty when the owner dies.
Always ask yourself: Does this investment make sense for me? A
high-yield, long-term CD with a maturity date of 15 to 20 years may
make sense for many younger investors who want to diversify their
financial holdings. But it might not make sense for every investor. If
Building Wealth is one of your long term goals - there is a science to getting rich!
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