Certificates of Deposit (CDs)

Certificates of deposit (CDs) are time deposits. When you choose a CD, the bank accepts your deposit for a fixed term—usually a preset period from six months to five years—and pays you interest until maturity. At the end of the term you can cash in your CD for the principal plus the interest you've earned, or roll your account balance over to a new CD. But you must tell the bank what you've decided before the CD matures. Otherwise the bank may automatically roll over your CD to a new CD with the same term at the current interest rate. And you might earn a better interest rate with a CD that has a different term, or one offered by a different bank.

CDs are less liquid than savings accounts. You can't add to or withdraw from them during the term. Instead, to buy a CD, you need to deposit the full amount all at once. If you cash in your CD before it matures, you'll usually pay a penalty, typically forfeiting some of the interest you've earned. To make up for the inconvenience of tying up your money, CDs typically pay higher interest than savings or money market accounts at the same bank, with the highest rates for the longest terms—though there are exceptions to this pattern. Like other savings accounts, bank CDs are insured by the FDIC, with your CD account balances counting toward your total insured amount.

CDs for Different Interest Rate Environments

In the past, each CD paid a fixed rate of interest over its term. But today you can also find variable rate CDs, sometimes called market rate CDs. With these accounts, the interest rate may rise and fall with changing market rates or be readjusted on a specific schedule. If the current rate is low, it may make sense to purchase a variable CD. That way, if interest rates rise, you won't miss out on the rate increase. On the other hand, if you expect rates to fall in the future, it may make more sense to buy a fixed-rate CD to lock in the higher rate for a specific term.

Another alternative is to create a CD ladder. You might start by dividing the amount you plan to invest in CDs into four equal amounts and buy four CDs with varying terms—say three months, six months, nine months, and one year. As each CD matures, you replace it with a one-year CD, so you have an amount to cash in or reinvest on a regular schedule. If you used a longer ladder, so that your CDs matured on an annual instead of a quarterly basis, you would never have all your money invested at the same rate, which would allow you to avoid locking in a large sum at a low rate.

Take Care With Long-Term CDs and Call Features

CDs are usually described, quite accurately, as conservative investments because of their FDIC insurance and relatively short terms. However, not all CDs are alike. In addition to regular CDs, whose terms are rarely longer than five years, banks may offer long-term, high-yield CDs that pay a much higher rate of interest for terms as long as 10 or 20 years. These CDs may be callable, which means that the bank has the right to terminate the CD and pay you back your principal plus the interest earned to that point. This usually happens if your CD is paying higher interest than CDs currently on the market, and it means you would have to reinvest your principal at a lower rate than your old one paid. However, unlike the bank, you don't have the right to end a CD contract if the situation is reversed and your CD is paying less than the current market rates.

In fact, you may want to think twice about any long-term CD because of the early withdrawal penalty. Generally speaking, investments that cost you money simply for changing your mind are rarely the best alternative.

Brokered CDs—Not Always FDIC Insured

You may also be offered a brokered CD by a stockbroker or other investment professional who serves as a deposit broker for the issuing bank. Brokered CDs may have a longer holding period than a CD you purchase directly from a bank, and they may be more complex and carry more risk. Although most brokered CDs are bank products, some may be securities—and won't be FDIC insured.

Brokered CDs differ in other ways from traditional CDs. For example, you may have to pay a fee to buy a brokered CD, either as a fixed amount or as a percentage of the amount you are investing. If the fee is modest and the CD is paying a higher rate than you could find on your own, you may come out ahead. But you should take the fee into account. You may also have to invest a minimum amount, such as $10,000 or more.

If the bank issuing the CD is FDIC-insured and if the CD is a bank product, your account value should be insured for up to $250,000. Keep these two things in mind, though: To be eligible for insurance, you must be listed as the CD's owner, so you'll want to confirm that it's registered to you or held in your name by a custodian or trustee. Second, if the issuer happens to be a bank where you already have money on deposit, the total value of your accounts could be higher than the amount of the insurance. If the bank fails, you might be vulnerable to loss.

Unlike a traditional CD, brokered CDs can't simply be cashed in with the issuing bank. As a result, some firms that offer brokered CDs may maintain a secondary market—but these secondary markets tend to be quite limited. If you want or need to liquidate your brokered CD before maturity, you may be subject to what's known as market risk. This means the CD may be worth less than the amount you invested because other investors are not willing to pay full price to own it. This might happen if the interest rate that new CDs are paying is higher than the rate on your CD.

Questions to Ask About CDs

Before you buy any CD, you should ask several questions:

  • What interest rate does the CD pay and what is the annual percentage yield (APY)?
  • Is the rate fixed or variable, and if it's variable, what triggers an adjustment and when does the change occur?
  • When does the CD mature?
  • What's the penalty for early withdrawal and are there exceptions to the early withdrawal fee?
  • Does the bank have the right to call the CD, and if so, when could that occur?
  • Is the issuing bank FDIC insured?

And if you purchase a brokered CD through a deposit broker, you should also ask the following additional questions:

  • Is the brokered CD a bank product or a security?
  • What is the name of the issuing bank?
  • Is the issuing bank insured by the FDIC?
  • Is the deposit broker someone you know—whose credentials you have checked?

CDs are useful additions to most investment portfolios because they offer safety and a predictable return. If you keep a portion of your assets in cash, CDs or U.S. Treasury bills are usually the most logical choices. And if you've been accumulating money to pay for specific goals, such as making the down payment on a home or paying tuition bills, you may want move some of this money into CDs as the date you'll need the money gets closer. That way, you can be sure you'll have it when you need it.