While the traditional certificate of deposit account remains the most popular type of CD, keep in mind that financial institutions offer a variety of non-traditional CD products. These specialized CDs have features that give savers more flexibility to benefit from rising rates, get early access to their funds or get better-than-average rates of return. If you’re willing to sacrifice some yield or tolerate some additional risk, you might find a CD better suited to meet your financial needs.
But first, what is a CD account?
A certificate of deposit is 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. There are a variety of different CDs:
With a traditional CD, you deposit a fixed amount of money for a specific term and receive a fixed 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 don’t allow you to add additional funds before your traditional CD matures.
Penalties for early withdrawal can be quite stiff and will cause you to lose interest, and possibly principal. Federal regulation — Regulation D, specifically — sets 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.
Before you pick a CD, it’s important to calculate how much interest you could earn by the end of your term.
A bump-up CD helps you benefit from a rising-rate environment. Suppose you buy a 2-year CD at a given rate, and six 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 on a bump-up CD than on a traditional 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.
Be sure you have realistic expectations about the interest-rate environment before buying a bump-up CD. See how bump-up CD deals stack up against traditional CD rates.
These CDs offer investors the opportunity to withdraw their money without incurring a penalty, although these types of CDs may come with strict withdrawal limits and large minimum investment requirements.
You can generally expect the interest rate on a liquid CD to be higher than that of a savings or money market deposit. But it’s usually lower than the rate on a traditional CD of the same term. You’ll have to weigh the convenience of liquidity against whatever return you’re sacrificing.
A key consideration when purchasing a liquid CD is how soon you can make a withdrawal after opening the account. Most banks require that the money stay in the account for at least seven days before it can be withdrawn without penalty, but banks can set the first penalty-free withdrawal for any time period. It’s important to read the fine print before picking up a liquid 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 (or 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 room in your budget to cover the taxes.
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 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 on to your shoulders. If it issues a 5-year CD at 3 percent and six months later rates drop by a full percent, the bank will drop its rate as well. It’ll now be paying 2 percent on the 5-year CD you originally got at 3 percent.
The bank can call, or take back, your CD and reissue it at the lower 2 percent. You’ll receive your full principal and interest earned. But you’re stuck reinvesting your money at lower rates.
Usually, banks pay a premium for taking on the risk that the CD may be called. They may pay investors a quarter- or half-percent more on a callable CD than they would on a CD without the call feature.
A brokered CD is simply a certificate of deposit sold through a brokerage firm. To qualify for one, you’ll need a brokerage account. Some banks use brokers as sales representatives to find investors willing to purchase the banks’ CDs.
Buying CDs through a brokerage can be convenient. There’s no need to open accounts at a variety of banks just to get the best CD yields. Brokered CDs may pay higher rates than CDs from your local bank because banks using brokered CDs compete in a national marketplace. But that’s not always the case.
Brokered 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.
Don’t assume all brokered CDs are backed by the Federal Deposit Insurance Corp. It’s up to you to do your due diligence and look for that on the broker’s website. You should also watch out for brokered CDs that have call options. And before you invest, check on fees and early withdrawal policies.
Banks compete for deposits by offering better-than-average rates. High-yield CD accounts may offer two or three times the national average on a given term. These are generally traditional CD accounts that pay very generous returns. 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.