The traditional certificate of deposit remains the most popular type
of CD, but a growing number of financial institutions are offering
a variety of nontraditional CDs that have an element of flexibility.
If you're willing to sacrifice some yield, you can find CD options
that might better suit your financial needs.
Here are the more popular types of CDs.
Deposit a fixed amount of money for a specific term and receive
a predetermined interest rate. You have the option of cashing out
at the end of the term, or rolling over the CD for another term.
Most institutions allow you to add additional funds during the term
or when rolling over. Penalties for early withdrawal can be quite
stiff and will cause you to lose interest and, possibly, principal.
Federal regulations stipulate only the minimum early withdrawal
penalty. There is no law preventing an institution from enacting
tougher penalties, but they must be disclosed when the account is
These allow you to take advantage of a rising rate environment.
Suppose you buy a two-year CD at a given rate and six months into
the term the bank is offering an additional quarter-point on two-year
CDs. A bump-up CD gives you the option of telling the bank you want
to get the higher rate for the remainder of the term. Institutions
that offer this option usually allow one bump-up per term.
The drawback is you may get a lower initial rate than
on a traditional two-year CD. The longer it takes interest rates
to rise, the higher they'll have to go to make up for the earlier,
lower-rate portion of the term. So, be sure you have realistic expectations
about the interest rate environment before buying a bump-up CD.
These offer consumers the opportunity to withdraw money from
the CD without incurring a penalty, although you may have to maintain
a minimum balance in the account to get that privilege. The interest
rate on a liquid CD should be higher than the bank's money market
rate, but would usually be lower than a traditional CD of the same
term and minimum.
A key consideration when purchasing a liquid CD is
how soon after opening the account you'll be able to make a withdrawal.
Federal law requires that the money stay in the account for seven
days before it can be withdrawn without penalty, but banks can set
the first penalty-free withdrawal for any period beyond that.
Another consideration is the number of withdrawals
allowed. You'll have to weigh the convenience of liquidity against
whatever return you're sacrificing when compared to similar term
CDs without the liquidity feature.
Most investors have heard of zero-coupon bonds, but did you
know there are also zero-coupon CDs? Just as with the bond, you
buy the CD at a deep discount to par value (the amount you'll get
when the CD matures). The word "coupon" refers to an interest
payment. Zero-coupon means no interest payments.
For example, if you buy a 10-year, $100,000 CD with
a 7 percent interest rate for $50,000, you wouldn't receive any
interest payments during the 10-year term. Instead, that money is
being invested. The problem is you have phantom income each year.
No money is being put in your pocket but you have to pay Uncle Sam
because you owe tax on the interest. You'd owe tax the first year
on $3,500 you haven't actually received. Each year you'll have a
higher base than the year before -- and a bigger tax bill. Make
sure you have the funds to cover the taxes.
The bank that issues the CD can "call" it away from you
after the call-protection expires, but before the CD matures. For
instance, if you buy a five-year CD with a six-month call protection
period, it would be callable after the first six months.
What's happening here is the bank is shifting interest
rate risk onto your shoulders. If they issue the CD at 5 percent
and six months later rates drop and the bank is now paying 4 percent
on five-year CDs, the bank can call, or take back, your CD and reissue
it at 4 percent. Of course, you'll receive your full principal and
interest earned to date. Usually, banks pay investors a premium
for taking on the risk that the CD may be called. They may pay a
quarter or half-percent more on a callable CD than they would on
a CD without the call feature.
A brokerage CD is simply a CD sold through a brokerage. Some banks
use brokers as sales representatives to find investors willing to
purchase CDs from their banks. Brokered CDs often pay higher rates
than CDs from your local bank because banks using brokered CDs compete
in a national marketplace. These CDs are more liquid than bank CDs
because they can be traded like bonds on the secondary market, but
there is no guarantee you won't take a loss. The only way to guarantee
getting your full principal and interest is to hold the CD until
maturity. Brokered CDs often have call options. They are backed
by the FDIC.
compete for deposits by offering better than average rates, but
the best route for finding the highest rates in the nation is Bankrate.com's
Highest Yields page.
Bankrate surveys local and national institutions to
find banks offering the highest yields on CDs. All accounts are
directly offered to the consumer by the institution.