Investors looking for low-risk investments that are easily convertible to cash should look into the certificate of deposit (CD). It is a special type of deposit account offered by most banks and thrift institutions around the country. Because it’s an instrument that provides stable return on your investment, CDs are considered to be more “secure” compared to stocks, mutual funds, and private equity investments. In addition, unlike other types of investment instruments, CDs have Federal Deposit Insurance worth up to $100,000.
The main concept behind CDs is that investors get a fixed return on their investments until it reaches maturity. However, like most other investment instruments in today’s market, there are now various types of CD features. Long-term CDs, Variable rate CDs, and high-yield CDs with “call” features are now available. The “call” feature basically means that the bank can terminate the CD after a certain amount of time. For example, the bank may decide to terminate the high-yield CD if the interest rate falls. The investor has no power to terminate the CD. If interest rates in the market significantly rise, they will be locked with the lower rate on their CD.
A lot of investors traditionally purchased their CDs through banking institutions. However, CDs are now also being offered by brokerage firms and independent sales personnel. These individuals or business entities are sometimes known as “deposit brokers” because they can negotiate a higher rate of interest by promising a specific amount of deposits to the banking institution. In this regard, it is important to look at strategies that can maximize the yield of your CD.
The CD Ladder
CD is similar to a typical savings account in the sense that this instrument accrues a fixed amount of interest over time. The major distinction between CDs and savings account is that the depositor is committed to hold the CD for a specified length of time, ie. 3 months, 6 months, 1 year, 2 years, etc. In exchange, the bank guarantees the rate of interest for this period.
CDs have the unique characteristics of having a fixed rate and lack of liquidity. Basically, if an investor purchases a CD that yields 3%, it will yield the same amount of interest for the duration of the CD. Even if the market rates fluctuate, the accrued interest of the CD will remain unaffected. Meanwhile, CDs are characterized by lack of liquidity because again, the term of the investment is fixed. The depositor cannot cash out their CD early without incurring penalty. Illiquidity is the main reason why CDs typically pay higher yields compared to savings account and money market funds.
Generally, CDs pay higher interest for longer terms. For example, a 5-year CD will yield more than a 1-year CD. However, financial experts would advice investors not to put all their money on the longest term CD to keep their liquidity.
Instead, investors can use the CD ladder to avoid or at least minimize illiquidity. The CD ladder acts like a hedge against market volatility. Assume that an investor has $4,000 to invest. Instead of putting the entire $4,000 on a 5-year CD, he can break it down to the following:
· $1,000 in a 2-year CD at 3.25% interest
· $1,000 in a 3-year CD at 3.50% interest
· $1,000 in a 4-year CD at 3.75% interest
· $1,000 in a 5-year CD at 4.00% interest
Once the 2-year CD matures, the investor can reinvest the money in a 5-year CD (it will mature in the 6th year) in order to benefit from higher interest rates. Investors can follow the process in your other CDs. That way, they will always be 1 year away from accessing 20% of their money without penalty. Though it may seem like a simple matter, having cash-at-hand is important for everyone. In addition, investors also get the chance to take advantage of better interest rates in case it is offered at the time of the CD’s maturity.
Tips in Purchasing CDs
- Determine when the CD matures – this is the first step you need to go through. Though it may seem obvious, there is a surprising number of investors who fail to confirm the maturity date of their investment. They are shocked to find out that they tied their money for five or even ten years when they try to withdraw it from the bank.
- Know the penalty for early withdrawal – before investing in CDs, it is important to determine how much penalty will be charge in case of early withdrawal. In some cases, investors risk losing a portion of their principal if they cash out early especially if they bought brokered CD.
- Confirm the yield of the CD – the investor needs to receive a disclose document that states how much the amount of interest rate on the CD will be. It should also contain how and how often the bank will pay the yield. For example, some banks pay the interest monthly while some disburse it semi-annually. The payment can be made through electronic transfer of by issuing a check.
- Find out if the CD has call features – as was discussed above, the call feature allows the bank to terminate the CD after a specific period of time but the investors do not have the same right. If interest rates fall, the banks may “call” it and you will be paid the principal plus any accrued interest. However, if the interest rates rise, you can be stuck with a long-term CD that pays below market rates. In addition, the investor wants to cash out before the maturity date, they will lose some of their principal.
- Understand what “Federally Insured One-Year-Non-Callable” means – the term doesn’t imply that the CD will mature in one year. It simply states that the bank cannot terminate the CD during the first year but the institution has the right to terminate it after one year has passed. Ask a representative of the bank if it isn’t clear when the CD will mature.
- Determine if the brokered CD is insured – the Federal Deposit Insurance limits their coverage to $100,000 per depositor in each institution. If an investor bought a brokered CD, it is important for them to find out which institution is the issuer of the investment instrument. The broker may be putting the money in a bank where the investor already has CDs and other deposits. In that case, they risk not being fully insured if their total deposit in the bank exceeds $100,000.
- Ask whether the interest rate can change – some forms of CDs have variable interest rates. These types of investment instruments have “multi-step” structures wherein the rate can increase or decrease based on a pre-set schedule. The varying rate can also be dependent on the performance of a specified index such as the Dow Jones Industrial Average.
Should You Invest in CDs?
Before deciding to invest in certificate of deposits, you should first determine what type of investor you are. There are basically three types of investors including conservative, moderate, and aggressive. Conservative investors usually invest in cash. They put their money on interest-bearing instruments such as savings accounts, mutual funds, Treasury Bills, and money market accounts. This type of investor prefers low-risk investments that grow over a lengthy timeframe.
Moderate investors usually invest in cash and in bonds. They may also dabble in riskier investments like the stock market. This type of investor has a moderate risk tolerance. Many of them also invest in real estate properties provided that this investment poses low to moderate risks. Last is the aggressive investor; they invest a significant amount of their money on the stock market. The aggressive investor also invests in high-risk business ventures.
If you are a conservative or moderate investor, the certificate of deposit is a good instrument for you. It provides a stable return on your money and your market exposure to risk is minimal. On the downside, the interest yield you can expect from CDs is also minimal compared to higher-risk investments. Meanwhile, if you are an aggressive investor, it may be better for you to invest your money in other types of investment instruments. That way, you won’t feel that your money is “tied up” when you want to invest in a seemingly good opportunity in the stock market.
However, beyond knowing your tolerance level for risk, it is more important for you to learn and understand the different types of investments instruments. In the end, your decision to invest in CD should depend on whether or not you are comfortable with the yield it gives and the level of risk it presents. Amidst today’s financial crisis, a lot of people are choosing to purchase CDs but only you yourself can decide if purchasing a certificate of deposit is right for you at this point.