What You Need to Know About Buying CDs
Savings rates have been in the bargain basement for years now, leaving some consumers to wonder whether opening a certificate of deposit is still worth the hassle.
Certificates of deposit, or CDs, generally pay higher returns than standard savings accounts because they're tied to a redemption date (not unlike bonds). That means consumers have to leave the money in place for a set time -- months or years -- before redeeming a CD, or else expect to lose any accumulated interest and possibly also pay an early withdrawal penalty.
With returns so low -- average rates for a 1-year CD stood at less 0.3 percent at the end of March, according to the latest survey by Bankrate.com -- consumers have little stomach for tying up their savings for an extended period of time in return for minuscule returns.
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Such low rates, combined with Americans' nervousness about the economy, is one reason so few Americans have enough savings to weather a financial emergency, says Greg McBride, Bankrate's chief financial analyst. "Savers are particularly reluctant to tying up money in a CD when uncertainty is so high," he says. "Their preference is for liquid savings they could get to at a moment's notice."
Given these drawbacks, does it still make sense to put your savings in a certificate of deposit? It depends on your personal finances. Despite the low rates, many older savers turn to CDs to generate a predictable stream of income without risk to the principal.
"CDs are a risk-free investment like U.S. Treasurys, but the top-yielding CDs are far better than what can be found on Treasurys," McBride says.
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As with other accounts held at banks, the federal government guarantees money held in CDs for at least $250,000, according the Federal Deposit Insurance Corp., so it's important to know just who is selling the CD.
Consumers who purchase CDs through a third-party broker should ensure the money goes where it's intended. "If the broker fails to place your funds into a CD at an FDIC-insured bank, your money will not be insured by the FDIC," says Martin Becker, chief of the FDIC's deposit insurance section. As with any investment, it's important to review the account agreement to confirm that you are in fact purchasing a CD and not some other financial product not insured by the federal government.
Here's what else you should before purchasing a CD:
What kind of CD is it? Certificates of deposit come in several flavors, including simple, fixed-rate CDs, as well as others with variable rates and market-linked CDs (also known as indexed or structured CDs), which are tied to a variety of indexes, including the Standard & Poor's 500 index, the Dow Jones industrial average, bond indexes and other securities. Market-linked CDs may take much longer to mature (as much as 20 years), compared to the typical 3 months to 5 years for traditional CDs, and the formula for calculating returns may be quite complex. Be sure to understand the formula before investing.
What are the withdrawal fees? If you withdraw money from a CD before it matures, you'll likely lose any interest accumulated on the investment and you may also have to pay a penalty. The fee could be a flat amount, equal to some months' worth of interest or a combination. The penalty may be charged even if you only wish to withdraw a portion of the money, though many banks don't permit partial withdrawals.
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Laddering can help. If leaving a big chunk of savings tied up for an extended period of time seems too risky, dividing it into equal portions among several CDs with different maturation dates, or laddering, may work for you. It works like this: Say you have $10,000 to invest. Rather than tying all $10,000 in a 5-year CD, you instead put $2,000 in a 1-year CD, another $2,000 in a 2-year CD, a third $2,000 in a 3-year CD and so on. Then, when the first CD matures after 12 months, you reinvest it into a 5-year CD, the same with the second one after two years, and continue. This structure provides you with a maturing CD every year, relieving some of the anxiety that may come up, should you need money for an unexpected expense. What's more, it allows you to take advantage of higher rates should interest rates start to rise.
Understand renewals. Once your CD matures, you can collect your savings and the interest earned and use it however you wish. But if you forget about the investment, chances are good that the bank will reinvest the money into a new CD, usually at a similar maturity at the prevailing interest rate. If that happens with a 5-year CD, for example, your money could get locked away for another five years. And if you want to withdraw the money before the new maturity date, you could be on the hook for early withdrawal fees.
David Schepp has spent more than two decades covering business news for the electronic and print media, including Dow Jones Newswires, BBC News Online, Gannett Co. and AOL's DailyFinance.
