The traditional certificate of deposit account is the most popular type of CD. But it’s far from being the only option available to consumers looking for a safe place to park their cash.
Financial institutions offer a variety of non-traditional CD products. These specialized CDs can give savers more flexibility when interest rates are falling, provide early access to their funds or offer better-than-average rates of return. If you’re willing to sacrifice some yield or tolerate some additional risk, you might find a CD better suited to meet your financial needs.
Table of Contents
What is a Certificate of Deposit?
A CD is an account used for storing savings. Funds are held for a certain period of time, or term, often ranging from three months to as many as 10 years. The most common CD terms offered by most banks include the one-year, 18-month, two-year, three-year, four-year and five-year CDs.
With a CD your money may be locked up for an extended period of time. But there’s good news: You’ll likely earn a higher yield than you would if you opened a standard savings account or money market account. You’re guaranteed to earn interest at a predetermined rate. And you’ll earn that much interest as long as you avoid making a withdrawal before your CD matures.
There are many different types of CDs to choose from. While CDs typically come with fixed rates, bump-up and step-up CDs allow account holders to increase their yield before the end of the term. Zero-coupon, callable and high-yield CDs potentially give you the chance to earn a more competitive rate and jumbo CDs require a high minimum deposit. Carefully consider which type of CD is best for you.
Key Things To Note
Today, things are a bit more complicated than just choosing a term and a rate. The good news is that the many options available today can make these savings vehicles more attractive. We’ll take a look at the types of CDs available today. As we do, keep two things in mind:
1. Early Withdrawal Penalties: Most CDs levy a penalty if you take your money out before the end of the term. Couple this with the fact that the longer the term the higher the rates, and you find yourself weighing your desire for more interest with the likelihood you may need your money sooner than expected.
2. Fixed Interest Rates: Once you open a CD, you’re generally stuck with the interest rate for the entire term, even if prevailing rates are on the rise. Of course, this is a great feature when rates are falling.
I mention these two aspects of certificates of deposit because the variety of options now available often give investors a way to mitigate these risks.
So now let’s look at the types of CDs and how best to put them to use.
Types of CDs
- No Penalty CD: As the name suggest, some certificates of deposit will not levy a penalty if you take your money out earlier. At first glance this may seem just like a savings account, but there are two significant differences. First, unlike a savings account, if you want to take some of your money out of a no penalty CD, you have to take all of it out. It’s all or nothing. Of course, you could turn around and open another one, but this quickly becomes a real chore. Second, the interest rate is fixed for the term of the CD, unlike a savings account where rates can fluctuate daily.
- A no penalty CD is ideal for an emergency fund or anything else where you may need your money on short notice.
- Bump Up CD: Also called a raise your rate CD, this option seeks to take the sting out of rising rates. Rather than sticking you with a rate for the entire term, if rates rise you can choose to take advantage of the higher rate for the remainder of the term. But there’s a catch (there’s always a catch). You only can exercise this option once during the term of the CD. So choose wisely.
- For example, suppose you buy a one-year CD at a given rate. If six months into the term the bank’s customers are offered a quarter percent more on CDs, a bump-up CD gives the consumer the option to tell the bank he/she wants to get the higher rate for the remainder of the term. By purchasing a bump-up CD, the consumer is taking the chance that rates will increase. The yield on bump up CDs is slightly lower than the yield on a CD with an equivalent duration without the bump-up option.
- Brokered CD: In this situation, your broker pools your money with other investors and buys a large CD from a bank. Often, this allows you to work around penalty problems. If you want to cash out early, a broker can frequently sell your investment to another investor. This may still result in a small loss, depending on how interest rates have changed since you purchased the CD.
- Brokerage CDs are traded on the secondary market and are very liquid; consumers can withdraw funds without facing a penalty, however the risk of losing principal is also present because of exposure to market volatility.
- Callable: A Callable CD is one that a bank can “call away” after a predetermined holding period. Normally, a bank will give you a premium rate during the time that this predetermined period is in effect. At the end of the period, however, the bank is able to take back the premium rate and offer the consumer a lower, prevailing market rate.
- This works to the bank’s advantage. If interest rates go down, the bank will likely exercise its option to call the CD after the holding period.
- Step Up or Step Down: A step up or step down CD is also known as a Flex CD. The Step Up or Step Down CD usually yields a fixed interest rate for a predetermined period of time, for instance, one year, after which the rate is automatically increased or lowered to a predetermined rate.
- Jumbo: A jumbo CD is sold in a large denomination, usually a minimum of $100,000 and is normally purchased by large institutional investors such as banks or pension funds. Jumbo CDs are also known as negotiable certificates of deposits and come in bearer form.
Shopping For The Best CD rates
As you may notice from the above descriptions, the characteristics of various types of CDs have a major impact on the interest they pay. So, for example, when shopping for CDs it doesn’t make much sense to compare the rate on a five-year CD at one bank with a one-year CD at another bank.
In order to make an apples-to-apples comparison, start by deciding which type of CD you are interested in. Then compare the interest rates on that specific type of CD from various banks. If you find more than one with essentially identical rates, a secondary point of comparison would be to see which has the least severe early withdrawal penalty, just in case you need to access your money earlier than expected.
Choosing the CD that fits your needs and then shopping for the best CD rates can add significantly to the interest you earn on your savings – and is the best strategy available for fighting back against low deposit rates.
The variety of CDs might be fun to explore, but remember that the purpose of a CD is to earn interest on some savings. Focus on rates above all, and consider what CD terms you need, since not every type of CD is available in every term. Once you’re ready, find the right CD to box in your money.
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