What type of CD account 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.

But first, what is a CD?

A certificate of deposit is a time deposit account; savers give the bank their cash for a set term in exchange for a series of interest payments.

Here are the more popular types of CDs.

Traditional CD

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 CD

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 Federal law requires that the money stay in the account for seven days before it can be withdrawn without penalty, but banks can set the first penalty-free withdrawal for any period beyond that.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

Zero-coupon CD

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.

One drawback is that zero-coupon CDs are usually long-term investments and that means you're taking on considerable interest rate risk. If interest rates rise during that 10-year period, you'll be on the losing end of that deal!

Another potential problem is you're credited with 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. In our example, you'd owe tax the first year on $3,000 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.

Callable CD

With a callable CD, 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.

Just as with the zero-coupon CD, the bank is shifting interest rate risk onto your shoulders. If it issues the CD at 3 percent and six months later rates drop, and the bank is now paying 2 percent on five-year CDs, the bank can call, or take back, your CD and reissue it at 2 percent. Of course, you'll receive your full principal and interest earned to date. But you're now stuck trying to reinvest your money at lower rates.

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.

Brokerage CD

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. It can be a convenient way to buy CDs, as you only need to have an account with the brokerage. There's no need to open accounts at a variety of banks just to get the better yields. 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.

It's easy to say that brokered CDs are backed by the FDIC, but you as the consumer must look for it in writing on the website or any printed materials you're given.

High-yield CD

Banks compete for deposits by offering better than average rates, but the best route for finding the highest rates in the nation is's 100 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.


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