Certificate of Deposits

certificate of depositCertificate of deposits, or CDs, are an interest earning savings instrument issued by a bank or thrift in which funds must remain on deposit for a specified amount of time; withdrawals prior to maturity incur interest penalties. CDs are also called a time deposits.

There are some CDs that are callable. They generally pay more than regular CDs but can be called in by the bank at specific dates. When called, you get back your principle and interest earned up to the call date. Banks will call a CD if interest rates have gone down since the CD was issued.

Brokered CDs, as the name suggests, are sold through a broker. This means that a person (such as yourself or financial advisor) surveys the marketplace to find the best CD rates available. Like other CDs, you agree to keep your money deposited for a specified term, and a bank agrees to pay you a certain amount of interest.

Why Do CDs Pay More Than Savings Accounts?

When you buy a CD, your bank pays a higher interest rate because you are keeping your money in the CD for a specified period of time. This gives them some certainty and ability to use your money for other purposes (such as lending it to other customers or investing it).

When is Interest Paid?

CDs have different options when it comes to paying interest on the account. Many CDs will deposit the interest into one of your accounts monthly or quarterly. Other CDs will add the interest back into the CD or pay the interest when the CD matures.

Watch Out

With so many investors are flocking to the safety of bank Certificates of Deposit, more marketing promotions are capitalizing on this. If you're not extra careful, you could wind up with an investment you don't want -- or find yourself a victim of outright fraud.

Don't assume that all promotions for CDs are from FDIC-insured institutions, or that all investments advertised by FDIC-insured banks are insured products. Insurance agents and brokers, for example, may advertise high-yield CDs to get you in the door, then try to sell you fixed annuities or other income investments. And with the investment banks becoming bank holding companies, more ads for securities soon may resemble those for FDIC-insured CDs.

Broker vs. Bank CDs

Many brokerages offers a type of certificate of deposit (CD) called a Brokerage CD. Brokerage CDs are issued by banks for the convenience of the brokerage firms’ customers. The deposits are obligations of the issuing bank. The CDs are usually issued in large denominations. The brokerage firm then divides them into smaller denominations for resale to their customers.

Brokerage and bank CDs both carry Federal Deposit Insurance Corporation (FDIC) insurance up to $250,000 per financial institution, per owner on each registration and $250,000 for qualified retirement accounts.

Investing in brokerage CDs is similar to bank CDs, in that investors agree to place their funds with the issuing bank for the term of the CD, and the CD earns interest at a specified rate. At maturity (or earlier if there is a call option) the investors' funds plus interest will be returned. During the term of the CD your funds will earn an interest rate stated at the time of initial deposit.

Brokered CDs can be purchased as a new issue or in the secondary market. Secondary market CDs range for 3 months to 20 years maturity date.

Ways to Manage CDs

CD Ladder

Just as you might use dollar-cost averaging to profit from fluctuations in the stock market, you can use a CD ladder to profit from fluctuations in interest rates.

Say you have $5000 to invest. To build a CD ladder, you would invest the money in CDs with staggered maturation dates:

  • $1000 in a one-year CD
  • $1000 in a two-year CD
  • $1000 in a three-year CD
  • $1000 in a four-year CD
  • $1000 in a five-year CD

As each CD matures, you immediately invest your money in a new five-year CD, effectively maintaining the one-year maturity date. You will always have CDs maturing every year for the next 5 years. You won’t earn the best possible rate of return, but you will earn a good one, and your income will be relatively constant. The CD ladder is also a form of diversification: you’re not betting all your money on one interest rate.

Parallel CDs

One of the biggest risks to your investment in a certificate of deposit is the need for early withdrawal. What if something happens and you need to pull the money out? As we’ve seen, this can be expensive.

Again, assume have $5,000 that you’d like to put into CDs. Instead of opening a single certificate of deposit for the full amount, consider opening multiple CDs. You might open three CDs at once, for example: two $1,000 CDs and one $3,000 CD.

This gives you a buffer in case you need to get at the money early. If you find you need $500, you can break a single $1,000 CD and the rest of your money is safe from penalty.

Auto Renewal

 Many banks will automatically renew your CD unless you instruct them not to. If you know you’re ready to pull your money out of a certificate of deposit, be sure to contact your bank to find out the proper procedure for doing so.

Advantages

  • Flexible terms: 30 days to 10 years
  • Very convenient to buy
  • Most are insured by the FDIC
  • Most pay interest every 6 months
  • Not a lot to get started - a few hundred dollars
  • A brokerage CD is portable and can be transferred from one brokerage firm to another, which allows the owner to consolidate assets at one firm.
  • Brokerage CDs may be traded on the secondary market and thus are generally more liquid than bank CDs. Although a brokerage CD will return an investor's principal at maturity, its value if sold prior to maturity will fluctuate based on size, time remaining before maturity and the level of interest rates.
  • Some states, such as Massachusetts, exempt state tax if the CD is bought from an in state bank.
  • Usually bank CDs pay better than brokered CDs.

Disadvantages

  • Money is tied up for the CD's term
  • No tax advantages. Taxed at Federal, state, and local level
  • No capital appreciation
  • Total return may not keep up with inflation

Tax Implications

CDs subjected to Federal, state, and any applicable local taxes unless held in a tax-deferred account.

Risks

Bank Failure (Credit Risk)

When a bank fails and the deposits are acquired by another bank, your existing CD essentially becomes a callable CD that can be closed by the new bank at any time. When interest rates are falling, you may want to consider the health of a bank if you want to purchase a CD, especially a long-term CD. If you open a 5-year CD at 5.00% and the bank goes under after one year, the receiver bank may decide to close the CD. At that time, you may be lucky to find a 3% CD. As part of its role in insuring bank deposits, the FDIC often seeks to find a financial institution willing to acquire the deposits of a failed bank, like ING did with Net Bank. The acquiring bank needs to make business decisions concerning the deposit base it is acquiring. Those business decisions include whether to honor the terms of the failed institution's deposit agreements.

Risks Associated With Brokered CDs

Credit unions are not FDIC insured, rather they are insured by the National Credit Union Administration (NCUA)– so they won’t be in the FDIC’s database. NCUA insurance is just as strong as FDIC insurance in my opinion.

  • Issuer risk - You should make sure that any issuing banks are safe and FDIC-insured. If the issuer becomes insolvent, the FDIC typically becomes the conservator. The CD may be sold to another institution or paid off prior to maturity.

  • Lower yields – Because of the inherent safety and short-term nature of a CD investment, yields on CDs tend to be lower than other higher risk investments.
  • Interest rate fluctuation – Like all fixed income securities, CD prices are susceptible to fluctuations of interest rates. If interest rates rise, the market price of outstanding CDs will generally decline. However, since changes in interest rates will have the most effect on longer maturities, short-term CDs are generally less susceptible to interest rate movements.
  • Credit risk – Since CDs are a debt instrument, there is credit risk associated with their purchase. The insurance offered by the FDIC may help mitigate this risk. Customers are responsible for evaluating both the CDs and the creditworthiness of the underlying issuing institution.
  • Market risk – CDs sold prior to maturity are subject to a concession and may be subject to a substantial gain or loss due to interest rate changes. The secondary market may also be limited. The market value of a CD in the secondary market may be influenced by a number of factors including, but not necessarily limited to, interest rates, provisions such as call or step features, and credit rating of the issuer.
  • Inflation - The CD will not earn interest at the rate of inflation.
  • Coverage limits – FDIC insurance limits apply to aggregate amounts on deposit at each covered institution. Investors should consider the extent to which other accounts, deposits or accrued interest may exceed applicable FDIC limits.

Costs

Typically your cost comes out in the Annual Percentage Yield (APY) that you earn on your money. This is similar to a bank – the bank does not usually charge you a fee to invest in a CD. However, the bank could pay you more or less depending on profitability concerns. The same is true for brokered CDs – your APY depends on how much any intermediaries want to earn on the deal. Bottom line: the commission a bank makes on selling a CD is not known to the buyer. The bank will probably not disclose it either.

Due Diligence

Before opening a CD, make sure the bank issuing the CD is insured by the FDIC. If the advertiser is not a bank, check the entity out with your state's securities regulator (NASAA.org) or insurance regulator (NAIC.org). Find out whether any complaints have been filed against the seller.
To ensure full FDIC coverage in the event of bank liquidation, know how a company will hold your CD. If it's not in your name, be sure account records reflect that the broker is acting as an agent for you and the other owners, such as "XYZ Brokerage as Custodian for Customers."

Information you need to know before buying a CD:

  • Maturity date
  • APY
  • How will you be paid (semiannually or when CD matures)
  • Call date, if any
  • Is the CD FDIC insured?
  • Is the full amount of the CD covered by the FDIC?
  • Can the CD be sold before maturity?
  • How will a company hold your CD (in your name, your broker's name)
  • Is there an auto-renewal on the CD?

Who would buy CDs

  • Conservative investor interested in safety and income

Where to Purchase

  • Your local bank
  • An online bank
  • Your broker
  • Credit union

Downloads

CD Comparison Spreadsheet

Resources

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