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What type of CD is best?

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.

Traditional

You 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 opened.

Bump-up

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.

Liquid

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 Federal law requires that the money stay in the account for seven days before it can be withdrawn without penalty, but banks can set the first penalty-free withdrawal for any period beyond that.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.

Zero-coupon

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 12-year, $100,000 CD with a 6 percent interest rate for $50,000, you wouldn't receive any interest payments during the 10-year term. Instead, that money is being reinvested. You'd receive the $100,000 face value when the CD matures.

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