Certificates of Deposit: Tips for Investors
Investors searching for relatively low-risk investments that can easily be converted into cash often turn to certificates of deposit (Certificate of Deposit). A Certificate of Deposit is a special type of deposit account with a bank or thrift institution that typically offers a higher rate of interest than a regular savings account. Unlike other investments, Certificate of Deposit feature federal deposit insurance up to $100,000. Here’s how Certificate of Deposit work: When you purchase a Certificate of Deposit, you invest a fixed sum of money for fixed period of time – six months, one year, five years, or more – and, in exchange, the issuing bank pays you interest, typically at regular intervals. When you cash in or redeem your Certificate of Deposit, you receive the money you originally invested plus any accrued interest. But if you redeem your Certificate of Deposit before it matures, you may have to pay an "early withdrawal" penalty or forfeit a portion of the interest you earned.
Although most investors have traditionally purchased Certificate of Deposit through local banks, many brokerage firms and independent salespeople now offer Certificate of Deposit. These individuals and entities – known as "deposit brokers" – can sometimes negotiate a higher rate of interest for a Certificate of Deposit by promising to bring a certain amount of deposits to the institution. The deposit broker can then offer these "brokered Certificate of Deposit" to their customers. At one time, most Certificate of Deposit paid a fixed interest rate until they reached maturity. But, like many other products in today’s markets, Certificate of Deposit have become more complicated. Investors may now choose among variable rate Certificate of Deposit, long-term Certificate of Deposit, and Certificate of Deposit with other special features.
Some long-term, high-yield Certificate of Deposit have "call" features, meaning that the issuing bank may choose to terminate – or call – the Certificate of Deposit after only one year or some other fixed period of time. Only the issuing bank may call a Certificate of Deposit, not the investor. For example, a bank might decide to call its high-yield Certificate of Deposit if interest rates fall. But if you’ve invested in a long-term Certificate of Deposit and interest rates subsequently rise, you’ll be locked in at the lower rate. Before you consider purchasing a Certificate of Deposit from your bank or brokerage firm, make sure you fully understand all of its terms. Carefully read the disclosure statements, including any fine print. And don’t be dazzled by high yields. Ask questions – and demand answers – before you invest. These tips can help you assess what features make sense for you:
Find Out When the Certificate of Deposit Matures – As simple as this sounds, many investors fail to confirm the maturity dates for their Certificate of Deposit and are later shocked to learn that they’ve tied up their money for five, ten, or even twenty years. Before you purchase a Certificate of Deposit, ask to see the maturity date in writing.
Investigate Any Call Features – Callable Certificate of Deposit give the issuing bank the right to terminate-or "call"-the Certificate of Deposit after a set period of time. But they do not give you that same right. If interest rates fall, the issuing bank might call the Certificate of Deposit. In that case, you should receive the full amount of your original deposit plus any unpaid accrued interest. But you'll have to shop for a new one with a lower rate of return. Unlike the bank, you can never "call" the Certificate of Deposit and get your principal back. So if interest rates rise, you'll be stuck in a long-term Certificate of Deposit paying below-market rates. In that case, if you want to cash out, you will lose some of your principal. That's because your broker will have to sell your Certificate of Deposit at a discount to attract a buyer. Few buyers would be willing to pay full price for a Certificate of Deposit with a below-market interest rate.
Understand the Difference Between Call Features and Maturity – Don’t assume that a "federally insured one-year non-callable" Certificate of Deposit matures in one year. It doesn't. These words mean the bank cannot redeem the Certificate of Deposit during the first year, but they have nothing to do with the Certificate of Deposit's maturity date. A "one-year non-callable" Certificate of Deposit may still have a maturity date 15 or 20 years in the future. If you have any doubt, ask the sales representative at your bank or brokerage firm to explain the Certificate of Deposit’s call features and to confirm when it matures.
For Brokered Certificate of Deposit, Identify the Issuer – Because federal deposit insurance is limited to a total aggregate amount of $100,000 for each depositor in each bank or thrift institution, it is very important that you know which bank or thrift issued your Certificate of Deposit. Your broker may plan to put your money in a bank or thrift where you already have other Certificate of Deposit or deposits. You risk not being fully insured if the brokered Certificate of Deposit would push your total deposits at the institution over the $100,000 insurance limit. (If you think that might happen, contact the institution to explore potential options for remaining fully insured, or call the FDIC.) For more information about federal deposit insurance, visit the Federal Deposit Insurance Corporation’s web site and read its publication Your Insured Deposit or call the FDIC's Consumer Information Center at 1-877-275-3342. The phone numbers for the hearing impaired are 1-800-925-4618 or (202) 942-3147
Find Out How the Certificate of Deposit Is Held – Unlike traditional bank Certificate of Deposit, brokered Certificate of Deposit are sometimes held by a group of unrelated investors. Instead of owning the entire Certificate of Deposit, each investor owns a piece. Confirm with your broker how your Certificate of Deposit is held, and be sure to ask for a copy of the exact title of the Certificate of Deposit. If several investors own the Certificate of Deposit, the deposit broker will probably not list each person's name in the title. But you should make sure that the account records reflect that the broker is merely acting as an agent for you and the other owners (for example, "XYZ Brokerage as Custodian for Customers"). This will ensure that your portion of the Certificate of Deposit qualifies for up to $100,000 of FDIC coverage.
Research Any Penalties for Early Withdrawal – Deposit brokers often tout the fact that their Certificate of Deposit have no penalty for early withdrawal. While technically true, these claims can be misleading. Be sure to find out how much you'll have to pay if you cash in your Certificate of Deposit before maturity and whether you risk losing any portion of your principal. If you are the sole owner of a brokered Certificate of Deposit, you may be able to pay an early withdrawal penalty to the bank that issued the Certificate of Deposit to get your money back. But if you share the Certificate of Deposit with other customers, your broker will have to find a buyer for your portion. If interest rates have fallen since you purchased your Certificate of Deposit and the bank hasn't called it, your broker may be able to sell your portion for a profit. But if interest rates have risen, there may be less demand for your lower-yielding Certificate of Deposit. That means you would have to sell the Certificate of Deposit at a discount and lose some of your original deposit –despite no "penalty" for early withdrawal.
Thoroughly Check Out the Broker – Deposit brokers do not have to go through any licensing or certification procedures, and no state or federal agency licenses, examines, or approves them. Since anyone can claim to be a deposit broker, you should always check whether your broker or the company he or she works for has a history of complaints or fraud. You can do this by calling your state securities regulator or by checking with the National Association of Securities Dealers' "Central Registration Depository" at 1-800-289-9999.
Confirm the Interest Rate You’ll Receive and How You’ll Be Paid – You should receive a disclosure document that tells you the interest rate on your Certificate of Deposit and whether the rate is fixed or variable. Be sure to ask how often the bank pays interest – for example, monthly or semi-annually. And confirm how you’ll be paid – for example, by check or by an electronic transfer of funds.
Ask Whether the Interest Rate Ever Changes – If you’re considering investing in a variable-rate Certificate of Deposit, make sure you understand when and how the rate can change. Some variable-rate Certificate of Deposit feature a "multi-step" or "bonus rate" structure in which interest rates increase or decrease over time according to a pre-set schedule. Other variable-rate Certificate of Deposit pay interest rates that track the performance of a specified market index, such as the S&P 500 or the Dow Jones Industrial Average.
The bottom-line question you should always ask yourself is: Does this investment make sense for me? A high-yield, long-term Certificate of Deposit with a maturity date of 15 to 20 years may make sense for many younger investors who want to diversify their financial holdings. But it might not make sense for elderly investors.
