Certificate of Deposit
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If you’re willing to tie up your money for a few months or years in exchange for a higher yield, then you want a short-term certificate of deposit (CD). CDs are simply deposits that you agree to keep at a bank or S&L for a certain time period in exchange for a set rate of return. Generally the return, or yield, you earn depends on how long you’ll leave the money with the institution, how much you’ll deposit, the general level of interest rates, and the competitiveness of the bank.
CDs come in a variety of time periods –or terms. The most common types are for three months, six months, one year, 2 ½ years, and five years. At the end of the term, you can either withdraw your principal and interest, or roll over the proceeds into a new CD for another term earning whatever yields are at the time. As long as you stick with institutions backed by the Federal Deposit Insurance Corporation and limit your deposits to less than $100,000 at any one institution, you will be completely protected against loss of principal. If you withdraw your money before the CD matures, however, you’ll pay a penalty and lose one month’s to one year’s worth of interest. Some of the top CD yields are available at brokerage houses, of all places. That’s because the brokerage firms can buy CDs in massive quantities and scour the country for the best rates around.CDs look marvelously simple. But don’t be fooled. Banks and S&Ls play lots of games with these certificates and you need to know the rules before you put a penny into any. Watch out for these two CD traps:
1.Interest rates that don’t reflect your true return. There are almost as many ways to compound interest as there are banks. Some compound your interest (or pay interest on your interest) each day. Some do it each month, each quarter, or each year. And others pay so-called simple interest, which means they don’t compound at all. A simple-interest CD isn’t necessarily a bad one; it all depends what rate the institution is paying. You could wind up earning more on a simple-interest CD than on one compounding quarterly, for example. To compare apples with apples, when you’re shopping around for a CD, ask the bank or S&L for the certificate’s annual percentage yield, which shows what really matters. The annual percentage yield will tell you the precise percentage increase you’d earn on your investment if you kept the CD for 12 months. Another way to compare CDs is to ask one simple question: How much money will I have at the end of the term of the certificate? That way, if you’re planning to deposit, say, $10,000 in a CD, you’ll see who will have paid you the most interest by the time the CD comes due.
2.Excessive penalties. Early withdrawal penalties are all over the map these days. And you can be sure that the penalty isn’t something you’ll find trumpeted boldly in any ad trying to lure your CD money. Some penalties are based on the cost to the bank to replace the funds you withdraw and can be calculated in a number of ways. One example: If you want to cash in a three-year, 4.5% CD after one year and the bank’s current interest rate for two-year CDs is 5.5%, then its replacement cost would be 2% of the face value (or 1% times two years). That kind of penalty can be extremely costly if interest rates have risen since you bought the CD.
Aside from asking about withdrawal penalties before you make a CD deposit, you can minimize the bite of a withdrawal penalty by spreading your stash among several CDs. Then, if you have to cash out a portion of your money early, you won’t pay a penalty on the entire principal; you can just take out a little from each of your CDs.
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