Friday, March 25, 2011

How a Certificate of Deposit Works

This is the 5th post in the Bank Deposit Account 101 series.

When I first heard about "CDs" in the same sentence as banking in high school, I was super confused. Ummmm...what do compact disks have to do with saving money? If you're as puzzled as I was, don't worry, I'm pretty sure most people have the same reaction. The abbreviation actually stands for Certificate of Deposit.

A CD is a deposit account offered by banks or credit unions that usually pays out a decently good amount of interest compared to your average checking and savings account. Of course, a higher rate of return for your money comes with a catch. This kind of savings vehicle is called fixed term or time deposit, meaning that you have to keep your money in the bank for an agreed period of time. The term can range from 3 months to 5 years. In general, the longer you leave the money and the larger the principal, the higher your interest will be. Jumbo CDs, those with a minimum deposit of $100,000, receive some of the best rates out there.

Interests are either paid at a fixed or variable rate. Fix rate CDs receive the same interest throughout its term. Variable rates can be done in several ways. Some will allow you to adjust to higher rates in the middle of the term. Others follow the rate of a certain index and make adjustments often. While this is an advantage when rates are steadily rising, it can hurt if interest rates fall.

Certificates of deposit are very low risk as long as the financial institution is insured by the FDIC or the NCUA. However, because of the set amount of time you agreed to keep the money in the bank, it's not as liquid as other kinds of deposit accounts. To prevent customers from closing their accounts before the maturity date, a penalty is imposed upon early withdraw. Sometimes, this can be a pretty hefty sum: a few months’ interest plus additional fees depending on the length of the deposit. The lowest penalty I found currently is with Ally Bank where you'll be charged just 60 days' interest no matter the time horizon of the account you hold. In other words, both the 3 month CD and the 5 year CD have an early withdraw fee of 60 days' interest. (In this case, it might be more beneficial to put your money in the 5 year account because of higher rates. We'll talk about strategies in a later post.)

Shortly before the CD matures, your banking institution will send you a notice. This will ask you for instructions of what to do with your principal and interest. There are two options: renewing the CD for another term or withdrawing the sum. If the bank doesn't hear from you within a certain period of time, they'll usually automatically roll over the account for another term. So make sure you reassess whether the rate you're receiving is still beneficial and respond in a timely manner. You don't want to be locked in if the rates at other banks or accounts have jumped higher. If used correctly, CDs can be a very good, low risk way to get more bang for your buck.


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