Investors seeking a low-risk investment that can be easily converted into cash often choose a certificate of deposit (CDs), a special type of deposit account with a bank or thrift institution that offers a higher rate of interest than regular savings account. And unlike other investments, certificates of deposit feature federal deposit insurance up to $100,000.
When an investor purchases a CD, he or she invests a fixed sum of money for a fixed period of time, such as six months, one year, or more. In exchange, the issuing bank pays interest to the investor typically at regular intervals. When the investor cashes in or redeems the certificate of deposit, the bank pays back the money originally invested, along with any accrued interest. However, if the investor redeems the certificate of deposit before it matures, he or she may have to pay an "early withdrawal" penalty or forfeit a portion of the interest earned.
Traditionally, most investors have purchased CDs through local banks, although many brokerage firms now offer them as well. Known as "deposit brokers" these brokerage firms may negotiate a higher rate of interest by promising to bring a certain amount of deposits to the institution. The broker can then offer these "brokered CDs" to their customers.
CDs once just paid a fixed interest rate until they reached maturity. But like many other products in today's market, they have become more in depth. Investors may choose from variable rate, long-term, and CDs with special redemption features in the event the owner dies.
Some of these long-term, high-yield CDs have "call" features, according to the Federal Deposit Insurance Corporation (FDIC). This means that the issuing bank may choose to terminate - or call - it after only a year or other fixed period of time. The investor does not have this option. For example, if interest rates fall, a bank may decide to call its high-yield certificates of deposit. However, as a long-term CD investor, if interest rates rise, the investor is still locked in at the lower rate.
Before purchasing a CD from a bank or brokerage firm, it's important to fully understand all of the terms. Make sure to read disclosure statements - including the fine print. The following tips may assist investors in assessing what features make the most sense:
1. Do you know when it matures? Make sure to confirm the maturity date. Believe it or not, investors have been known to mistakenly tie up their money for years at a time. Ask to see the maturity date in writing before purchasing a certificate of deposit.
2. When purchasing a brokered CD, identify the issuer. Federal deposit insurance is limited to a total amount of $100,000 for each depositer in each bank or thrift institution. Therefore, investors should be clear on which bank or thrift will issue it, or where the deposit broker plans to deposit the money. Investors should be assured that his or her CD will have federal deposit insurance.
3. Investigate call features. Callable CDs give the issuing bank the right to terminate it after a set period of time, however the investor does not have the same right. Investors should receive the full amount of his or her original deposit plus any unpaid accrued interest if a bank redeems a CD.
4. Understand the difference between call features and maturity. Some investors make the mistake of assuming that a "federally insured one-year non callable" certificate of deposit matures in one year. Investors should clarify with a sales representative at the bank or brokerage firm a CD's call features and its date of maturation.
5. Investors should confirm the interest rate they will receive and how he or she will receive payment. Investors should receive a disclosure document explaining the rate of interest and whether the rate is fixed or variable. Also, the bank should explain how pay out will be received - by check or electronic transfer of funds.
6. Research penalties for early withdrawal. An investor should know how much he or she will have to pay for cashing a CD in early before maturity.
7. Investors should be informed about any other additional features, such as a death benefit that will allow a certificate of deposit's owner's heirs to redeem the CD without penalty if the owner dies.