How Much Do You Know About Certificates of Deposit? — Your Questions Answered
A Certificate of deposit (CD) is a safe, low-risk, and potentially high-return investment. It is a time investment where you lock in money in a CD account for an agreed period within which it earns interest. At the end of the investment tenure, the selling institution pays you the full sum of principal and interest.
The Federal Deposit Insurance Corporation (FDIC) insures bank CDs, so you never have to worry about losing your money. Anyone can invest in a CD, but they are of more benefit to people who want to invest lump sum amounts where liquidity is not a priority. Most CDs use the compounding method of calculating interest. Compounding can be done daily, monthly, quarterly, semi-annually, annually, and so on.
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What are Certificates of Deposit?
A Certificate of Deposit is a time investment where you deposit a certain amount of money into a CD account over a specified time and earn interest on it. CD tenures are usually short term; about 6 months, or long-term; up to 5 or more years. Each term has a pre-determined interest rate, which is higher with longer tenures. Certificate of deposit accounts earns a much higher interest rate than savings accounts, although savings accounts are more liquid.
CDs are a favorite of many just like government securities because of their low-risk nature, among other benefits. Although they are subject to various types of investment risks such as inflation and opportunity risks, you can be sure that your initial investment is safe.
Where can you buy a CD?
You can get a Certificate of Deposit from a bank, Credit Union, thrift institution, or even a broker operating on behalf of any of these institutions. Almost all banks offer CDs, making it quite an easy process to get a CD from a bank. Wherever you get it from, ensure the CD is insured. FDIC insures bank CDs while the National Credit Union Administration (NCUA) insures Credit Union CDs.
What are the CD interest rates and required minimum deposit?
The minimum amount of money you should deposit, the interest rate, and the period of investment vary from bank to bank. There are banks that may not require a minimum deposit for a CD account. You need to shop around various banks for the best deals.
Fixed vs floating rate, which is better?
While most CDs offer a fixed rate of return, you can benefit from a varying rate of return depending on the type of CD account you have. Variable-rate CDs are, however, riskier because the interest rate could go either way. You lose if interest rates drop. With a fixed account, the interest rate is the same throughout the period. Floating rates are usually adjustable within a specific period, for example, after every three months. In this case, you will earn interest quarterly.
Can you access your money before maturity?
You can access your money before the maturity period if you are holding a non-negotiable CD, but you will pay a penalty. A non-negotiable CD is one which you cannot sell to or buy from a third party, but you can cash it before maturity with a penalty payment. Non-negotiable CDs are usually short term CDs of a year or less. On the other hand, a negotiable CD is one which you can buy from or sell to a third party. You cannot cash a negotiable CD before maturity. They are usually long-term CDs of $100,000 or more.
With a liquid CD account, however, you can make penalty-free withdrawals. For this reason, a liquid CD account offers lower interest rates.
How do you mitigate various types of CD investment risks?
CDs do face two major types of risks — Interest rate risk, which breeds reinvestment and opportunity risk, and inflation risk. Interest rate risk is the risk of interest rates rising or going down while your CD funds are held up. Inflation risk is the risk of money losing value, which means a decrease in its purchasing power. It is crucial to study the market for any expected increase or decline in interest rates so that you can choose a CD wisely.
CD accounts that minimize interest rate risk
1. Short-term traditional CDs
These are the most popular types of CDs. With the assumption that interest rates may not change much in the short-run, short-term traditional CDs cushion you against a fall in interest rates within that period. The return you receive remains the same even if interest rates fall. You can always withdraw your amount after the expiry of your tenure and take advantage of any existing higher interest rates.
2. CD ladders
Apportioning your money in investments with varying risks is a wise way to keep your money safe and take advantage of various interest rates. That is the purpose of Certificate of Deposit ladders. When you invest in a CD ladder, you put your money in different CDs with different interest rates and maturity dates. For example, you can apportion money in 1-year, 2-year, 3-year, and 4-year CDs. Once the 1-year CD matures, the other three CDs move one year up the maturity ladder, meaning you can re-invest in a 4-year maturity CD. This way, you always have an investment in place and reap the benefits of different interest rates.
3. Bump-up CD
A bump-up CD allows you to take advantage of rising rates of interest. If interest rates rise while you are within your CD tenure, you request the bank to calculate your interest for the remaining term using the new higher interest rate. On the downside, you can only claim one bump-up in a term, and the initial interest rate for this kind of arrangement is lower. You need to do a proper analysis of the market to determine the probability of interest rates increasing before settling for a bump-up CD.
4. Step-up CD
With step-up CDs, the bank automatically increases your interest rate periodically. This model is especially suitable in a market where interest rates are continually rising.
CD accounts that minimize inflation risk
1. Inflation-linked CD
An inflation-linked CD is a CD whose interest rates vary with the Consumer Price Index (CPI), which is a measure of inflation. As an investor, you will get extra returns based on inflation, which cover the inflationary risk. One of the downsides of an inflation-linked CD is that the interest rate is lower than other types of CDs. They are, therefore, not ideal for those who want to realize huge gains.
How to calculate CD interest
Most people get caught up in the calculation of interest rates and with good reason. There are various types of interest rates. For CD, mostly compounding is used. A CD can be compounded daily, monthly, semi-annually, yearly, and so on. Most institutions, however, compound monthly.
Example 1: Monthly compounding
Assume a 5-year CD with an investment amount of $5000 and an interest rate of 7%p.a compounded monthly.
Monthly interest rate: 0.07/12= 0.0058
Interest month 1: $5000*0.0058 = $29
Interest month 2: ($5000+$29)*0.0058 = $29.17
Interest month 3: ($5029+$29.17)*0.0058=$29.34
…and so on.
Example 2: Assume an 5-year CD with an investment of $5000 and an interest rate of 7.09%p.a compounded quarterly
Quarterly interest rate of interest: 0.0709/4=0.0177
Interest after 3 months: $5000*0.0177=$88.50
Interest for the next 3 months: $5088.5*0.0177=$90.07
…and so on
Calculating interest rate using APY
APY stands for Annual Percentage Yield, which is the annual interest rate that factors in compounding, by including previously accrued interest. APY is useful when you want to compare two or more CDs with different interest rates and different compounding periods to determine which earns a better return.
APY using Example 1 above:
APY= (1+r/n)n n-1 where n represents the number of compounding periods in a year and r is the annual interest rate.
Therefore, our APR will be: (1+0.07/12)12* -1 = 7.23% (*12 is a power)
The annual interest will be: $5000*0.0723 = $361.50
Example 2: APY will be: (1+0.0709/4)4*–1=7.27% (*4 is a power)
The annual interest will be: $5000*0.0727=$363.50
From the APY results, the second CD with a rate of 7.09% compounded quarterly will yield a higher return than the first CD with a 7% rate of return compounded monthly.
Main features of Certificate of deposit accounts
· Flexible tenure starting from 6 months to over 5 years.
· You pay a lump sum amount into an FD account which you cannot top-up unless you have opened an Add-On CD.
· Withdrawals are not allowed until the expiry of the period unless with a penalty.
· The investor gets a receipt which they present to the selling institution upon maturity to make withdrawals.
· The traditional CD has a fixed rate of return.
Advantages of a Certificate of deposit account
· Assured pay.
· Returns are fixed for a traditional CD regardless of market fluctuations.
· You can re-invest the money in a new FD account.
· Some banks allow you to choose how you want to receive interest; either monthly, annually, or at maturity.
· You do not have to have an account with a bank to open a Certificate of deposit Account.
· Flexible tenures.
· Ease of withdrawal.
· Inculcates a savings culture due to the fixed term.
· You can get a loan which is 75–90% of your CD amount, which can help you during emergencies.
· You get to save on taxes if your Certificate of deposit account runs for 5 or more years.
Disadvantages of a Certificate of Deposit
· You get penalties if you withdraw before maturity
· Interest rates are higher than those of a savings account but lower than those of other investments such as bonds and shares.
· Long-term investments are more prone to inflation and interest risk.
· You do not get a loan for Certificate of deposit accounts which run for 5 or more years.
· It is not suitable for saving small amounts regularly, as you cannot top-up.
How to get a good deal — what to look out for when purchasing a CD
· Write down your goals to determine which CD can meet those goals — If you aim to receive high returns, you can settle for a high-return CD account or one which allows you to take advantage of higher interest rates such as a CD ladder or a step-up CD. If you only want to save your surplus money, having a traditional fixed account could work for you.
· Fund your CD earlier to take advantage of higher interest rates — When you open a CD account, you will have several weeks to fund the account. You can fund your account any time within that period, but if you fund it within the first 10 days, some banks will offer you the highest rates.
· Frequency of compounding — The higher the frequency of compounding, the greater the earnings if you are comparing two CDs with a similar rate of return. However, if the rates of return are different, you may need to calculate APY to determine which investment will yield more returns.
· Automatic renewal — inquire if there will be automatic renewal once the tenure of your account expires to avoid inconvenience. Automatic renewal mainly happens for tenures above one year. The offering institution should inform you days before your tenure expires so you can decide if you want to withdraw your money or renew the CD.
· Shop for best interest rates — Shop around financial institutions to find out which one has terms that are most favorable to you.
· Ensure you buy a CD from an insured institution — Whether it is a bank or a credit union, ensure it is insured by the Federal Deposit Insurance Corporation or the National Credit Union Administration. With an insured CD, you can recover your money if the institution defaults for whatever reason.
· Be cautious when buying a CD from a broker — Brokered CDs can be more difficult to claim. Always ensure you carry out a background check to ensure the CDs are insured.
· Ask about their frequency of interest payment — Interest can be paid monthly, quarterly, semi-annually, and so on. It is good to know your options, especially if liquidity is a concern for you. However, if you choose to receive interest payments within your tenure, you may not benefit from interest compounding.
· Check out minimum deposit requirements and ensure you can meet them.
· Watch the market to stay aware of expected interest rate hikes — You can purchase a short-term CD, cash it out before the expected interest hike period, and put it into a new CD with higher interest rates.
· Compare early withdrawal fee penalties charged by different institutions. Ensure you settle for the one with the least costs, just in case you may need to withdraw your money during an emergency.
Always ensure that the CD account you have matches your short or long-term goals. Get all the information you need to before settling on a specific CD account.
I hope this article has answered most of your questions on Certificates of Deposits. Feel free to leave a comment or question and I will check it out!