CDs are popular investments because they promise safety and interest income.
When you put money into a bank certificate of deposit (CD), you expect to get it back at a specific time, plus the interest it has earned. In return for that security, you agree to leave your money on deposit for a specific period of time, typically ranging from six months to five years. The minimum deposit is often $500, but there's rarely a
ceiling, or upper limit. In investment terms, the money you put in is known as your
principal. The length of the CD is its
term, and the time it
matures, or ends, is its
date of maturity.
CHOOSING CDS
One of the first things you look for in a CD is the interest rate it pays and the
annual percentage yield (APY), since they determine what you earn. Generally, with a longer term, you get a higher rate, to make tying up your money more attractive. But rates can vary significantly from year to year, as what a bank pays on its CDs and other deposits reflects the level of interest rates in the economy as a whole.
You can buy CDs through almost any bank, and can often handle the entire transaction by mail and telephone. Many people use a local bank for convenience. But if the rates offered at a distant bank are substantially higher, you may decide it's a smarter choice, especially for large deposits. You can get a sense of current rates for CDs of various denominations in the financial pages of many newspapers and on financial websites.
WHAT HAPPENS AT MATURITY
When a CD matures, you decide what you want to do with the principal, but you may have to tell the bank in writing what you've decided within the time limit it imposes. If you wait too long or never give instructions, the bank can sometimes
roll over, or reinvest, your money in another CD for the same term at the current rate.
You might ask for a rollover in any case. But if you need the money, if the new rate will be lower than the interest you've been earning, or if you could earn more on a different investment, you might decide to get out of CDs. In that case, you can ask the bank to
sweep, or move, the money into another of your accounts, transfer it electronically to another bank, or send you a check. There may be a fee for the transfer.
BUYING FROM A BROKER
You can also buy a CD through a stockbroker.
Brokerage houses, firms that buy and sell stocks and other investments, buy large-denomination bank CDs, break them into smaller units, and sell them to individual investors. Because you own only part of a CD, you're not committed to holding it to maturity and can cash it in without penalty at any time. However, there does have to be a buyer willing to purchase at the rate the CD pays.
You may get a better interest rate with a broker CD, too, if the large underlying CD pays more. The trade-off for the earnings often means paying a
commission, or sales charge, to the broker who sells you the CD, something you don't pay for a bank CD. You'll also want to be sure that you'll be eligible for FDIC insurance with the CD. Among the questions to ask is which bank issued the underlying CD.
COMPOUNDING IS KEY
What you actually earn on your CD, in dollars and cents, is the
yield — specifically the annual percentage yield (APY). The yield depends on whether the interest is
simple or
compound, and how often it's compounded.
Simple interest may be paid only once a year, on the amount of your purchase, while compound interest can be paid on a variety of schedules, from daily to semi-annually, on the growing balance in your account. Here's an example of how interest is compounded when it's paid quarterly.
USING CDS
If you have regular expenses, like tuition payments, or anticipate having to cover a large cost at a specific time, you can time your CDs to come due when you need the money. Banks may be flexible, too, if you ask for a special term. For example, if you are planning to buy a house in seven months, you may be able to get a customized seven-month CD at a slightly better rate than a regular six-month variety.
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