The traditional CD remains the most popular type of certificate of deposit, but financial institutions also offer a variety of nontraditional CDs that can be more flexible than the regular kind. If you're willing to sacrifice some yield, you might find a CD option better suited to your financial needs.
But first, what is a CD?
A certificate of deposit is what's known as a time deposit account; a bank agrees to pay interest at a certain rate if savers deposit their cash for a set term, or period of time.
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Here are 7 popular flavors of CDs:
- Traditional CD
- Bump-up CD
- Liquid CD
- Zero-coupon CD
- Callable CD
- Brokerage CD
- High-yield CD
1. Traditional CD
With a 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 set only the minimum early withdrawal penalty for traditional CDs. There is no law preventing an institution from enacting tougher penalties, but they must be disclosed when the account is opened.
2. Bump-up CD
This type of CD allows you to take advantage of a rising-rate environment. Suppose you buy a 2-year CD at a given rate, and 6 months into the term the bank offers an additional quarter-point on the same investment. 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 CD option usually allow only one bump-up per term.
The drawback is you may get a lower initial rate than on a traditional 2-year CD. The longer it takes interest rates to rise, the longer it will take 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.
3. Liquid CD
These CDs offer consumers the opportunity to withdraw their money without incurring a penalty, although the depositor may have to maintain a minimum balance in the account. You can expect the interest rate on a liquid CD to be higher than the bank's money market rate, though it's usually lower than the rate on a traditional CD of the same term and minimum.
A key consideration when purchasing a liquid CD is how soon you can make a withdrawal after opening the account. Federal law requires that the money stay in the account for 7 days before it can be withdrawn without penalty, but banks can set the first penalty-free withdrawal for any time beyond that.
Another thing to think about 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.
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4. Zero-coupon CD
These CDs are similar to zero-coupon bonds. As with the bond, you buy the CD at a deep discount to its par value. (In other words, the amount you'll receive when the CD matures.) "Coupon" refers to a periodic interest payment. Zero-coupon means there are no interest payments.
So, you might buy a 12-year, $100,000 CD for $50,000, and you wouldn't receive any interest payments over the course of the term. 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 you take on considerable interest-rate risk. If interest rates rise during the 10-year term in question, you'll be on the losing end of that deal!
Another potential problem is that you're credited with phantom income each year. No money is being put in your pocket, but you'll have to pay Uncle Sam on the earnings being accrued. In our example, you'd earn $3,000 during the first year and would owe tax on the money, though you haven't actually received it. 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.
5. Callable CD
With a callable CD, the bank that issues the CD can "call" it away from you after your call-protection period expires, and before the CD matures. For instance, if you buy a 5-year CD with a 6-month call-protection period, it would be callable after the first 6 months.
Just as with the zero-coupon CD, the bank is shifting interest-rate risk on to your shoulders. If it issues the CD at 3% and 6 months later, rates drop, the bank is now paying 2% on 5-year CDs. The bank can call, or take back, your CD and reissue it at 2%. You'll receive your full principal and interest earned to date. But you're now stuck reinvesting your money at lower rates.
Usually, banks pay a premium for taking on the risk that the CD may be called at. They may pay investors a quarter- or half-percent more on a callable CD than they would on a CD without the call feature.
6. Brokerage CD
A brokerage CD is simply a certificate of deposit sold through a brokerage. Some banks use brokers as sales representatives to find investors willing to purchase the banks' CDs. A brokerage 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 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.
You may assume that brokered CDs are backed by the FDIC, but it's up to you to do your due diligence and look for that in writing on the broker's website or any printed materials you're given.
7. High-yield CD
Banks compete for deposits by offering better-than-average rates, and Bankrate offers the best route for finding the highest rates in the nation.
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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