Interest Features of CDs
Certificates of deposit have a place in almost every investor's portfolio. For older investors, CDs provide safety at a higher interest rate. For younger investors, they offer an additional way to save for expensive items like the down payment on a first house, a car, or a 6 to 12 month emergency reserve fund. But like most investments, CDs have become increasingly complex in recent years. Banks and thrifts have introduced a number of different CD products with varying interest features to attract investors with different savings goals. While investing in a certificate of deposit won't make anyone rich, it does provide several advantages over other types of low-interest savings vehicles.
Interest features of CDs are fixed rate, variable rate, contingent rate, and zero-coupon. Below you'll find a description of the different types of CDs, their interest features, and the type of investor for whom they are best suited.
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Traditional Certificate of Deposit
A traditional CD is a time deposit. A fixed amount of money is used to purchase the CD for a specific term. The interest rate that is paid by the bank is known at the time the CD is purchased. At the end of the term, which is also known as the maturity date, the investor has the option of cashing out the CD or rolling it over into another term.
Traditional CDs are typically issued for terms ranging from 6 to 60 months, although they can be issued for 120 months or longer. While the amount of interest that is paid varies by bank, traditional CDs can pay a higher rate of interest than a traditional savings account or money market account. They're best for those who want to boost their earnings over a short period of time without taking any additional risks.
If you're thinking of purchasing a traditional CD, it's important to remember that the interest rate is locked in at the time of the purchase. This is an advantage when interest rates are expected to fall but a disadvantage when they are expected to rise. Therefore, traditional CDs are usually recommended for younger investors with short-term savings goals or those who are waiting for other investment opportunities to come along. Older investors, especially those who are receiving mandatory individual retirement account or 401(k) distributions also choose traditional CDs as a place to save the payouts they don't need for day-to-day living expenses.
Bump-Up Certificate of Deposit
In an environment of rising interest rates, the Bump-Up CD allows an investor to take advantage of an increase. For example, an investor who purchases a 36-month Bump-Up CD with a guaranteed rate of 2.75% would be able to take advantage of a higher rate if the bank were to offer it. If at some point during the 36 months the bank were to offer a 36-month CD at 3.0%, the owner of a Bump-Up CD would be able to get the higher rate for the remainder of the term.
Bump-Up CDs are best for investors who believe that interest rates will rise at some point during the term. The bumped-up rate can usually only be applied once during the term, and Bump-Up CDs typically pay a lower interest rate to begin with than other types of CDs. If you feel interest rates will rise in the near future, the alternative to a Bump-Up CD is a traditional CD with a shorter term.
Liquid Certificate of Deposit
As stated earlier, CDs are set for a specific period of time. Money cannot be withdrawn before the maturity date without penalty. For this reason, CD investors must always make sure they keep enough cash in other accounts, such as checking and savings accounts, to meet day-to-day living expenses. A liquid CD, however, combines the higher interest rate of a traditional CD with the withdrawal features of a savings or checking account.
The interest rate that is paid on a liquid CD is typically higher than a savings or money market account, but less than a traditional CD. In order to guarantee the interest rate, most banks will require an investor to keep a minimum balance in the CD. For example, the bank may require that a liquid CD purchased with $10,000 have a minimum balance of at least $7,500, which will allow withdrawals up to $2,500.
Liquid CDs are a good investment for those who want to maintain a 6 to 12 month emergency fund. This type of CD will pay a higher rate than a regular savings account and allows withdrawals to be made without penalty. As long as the amount withdrawn won't reduce the balance below the minimum, a liquid CD is perfect as a cash safety net. It's a good idea, however, to ask about and understand all of the regulations established by the issuing bank. There may be a limit to the number of withdrawals that can be made during the term and there may be a restriction regarding how soon money can be taken out after the initial purchase.
Zero-Coupon Certificate of Deposit
Zero-coupon CDs function in much the same way as zero-coupon bonds. The CD is purchased at a discount to the par value (the dollar value of the CD at maturity). Because there are no coupons, the bank does not pay interest at regular intervals.
While this type of CD can be appropriate for investors with a longer investment timeframe, it is not suitable for those who cannot afford to pay the taxes on the interest earned without having first received the income. Taxes are due on the interest earned before it is credited to the account. And, because the interest compounds and the value of the CD grows each year, the tax liability increases each year.
Zero-Coupon CDs should be considered as an investment vehicle rather than a saving vehicle. They should only be considered as part of an overall investment strategy and portfolio and not for an emergency fund.
High-Yield Certificate of Deposit
High-Yield CDs pay a higher rate than any other type of CD. However, the terms are often much more strict than other CDs and investors may be subject to more severe early withdrawal penalties. High-Yield CDs should only be purchased with money that definitely won't be needed for the duration of the term.
Choose the Right CD
Investors should carefully consider all of the CD options available against their saving and investing goals before making a purchase. While a traditional CD may be the right choice for someone looking to earn a little more interest each year, a callable CD is a better choice for an investor who will not need to access the money during the term. In some cases, two or more CDs might even be right for one individual investor.
While we've covered the basics of CD investing here, CDs should only be part of a long-term investment strategy. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
More CD Guidance
- CD Investment Guide — The complete guide to bond investing.
- CD Redemption Features — Explore the redemption features of CDs.
- Best CD Rates — How to find the best CD rates.
- CD Investment FAQ — Frequently asked questions about CD investing.