Financial Literacy Month: CD’s

by Matt B

CD’s, or Certificates of Deposit are “time deposits” that can be opened at most banks, credit unions and savings and loans.

A Certificate of Deposit most commonly comes in 3 and 6 month or 1,2,3,4 or 5 year terms. CD’s are insured deposits, so they offer an attractive investment option for those looking for low-risk. Once the CD is opened, your money is “locked” for the term of the account. Nearly every aspect of CD’s can be variable in some way. Interest rates, term length, and deposit amounts can all be different, depending on the needs of the account holder’s preferences.

Terms:
While some CD’s can mature in as little as 30 days, most carry a term of at least 90 days. With variance of length comes fluctuation in interest. Longer terms usually yield a higher Interest rate. Since a CD is in essence a loan to the institution, early withdrawal may incur a penalty. If you feel that you may need the funds before the CD term is up (mature) the penalty may sting you worse than if the funds were originally placed in a savings account.

Interest Rate:
Rates on CD’s are usually higher than a traditional savings or money market account. Finding the best rate is simple

Drawbacks:
CD’s do not have a lot of downside. One of the worst things that can happen is a change in interest rate. If you have a 5 year CD at 3% interest, and the rate rises even a small amount during the term, depending on how much you have invested, you could be losing a considerable amount of interest payments. Unlike many retirement accounts, CD’s are not tax free. Taxes must be paid on interest earned from CD’s, just like savings accounts. Only one deposit can be made to a CD account. Additional funds can not be added to a CD during the term.

Because CD’s are FDIC insured, the depositor need not worry about losing the investment (up to $250,000).

Laddering:

One popular method of CD investing is called laddering. It is a simple method, and often yields a higher return due to rate changes. Let’s say you have $5,000 to invest in CD’s. To create a CD ladder with these funds, you would invest $1000 in a one year CD, $1000 in a two year CD, and so on until you have 5 CD’s all at a different term. After the first year, when the first account matures, if you would like to reinvest the funds in another CD, you open a new five year account, as the funds from the two year CD will be mature in one year. After the first accounts are opened, each year, a new five year CD will be opened, see? – ————————————————————————————— –

When searching for CD rates, you should always compare your local bank rates to the internet bank rates available. Internet banks often have less overhead and can offer very competitive CD rates. When opening a CD, you should take the same approach you would when looking at credit card offers and carefully read the terms and conditions. In particular always know what the early withdrawal penalty is on your CD.

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{ 2 comments… read them below or add one }

Miranda April 22, 2009 at 8:50 am

Great post on CDs! I find that laddering can be helpful in some cases. But I find that I enjoy a money market account or rewards checking. In some cases the rates are often as high or higher, and you don’t have to worry about withdrawal penalties.

Heyagainlando April 22, 2009 at 11:41 am

Thanks Miranda!

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