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Helpful
Information
Investors
searching for relatively low-risk investments that can easily be
converted into cash often turn to certificates of deposit (CDs). A
CD 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, CDs feature
federal deposit insurance up to $100,000.
Here’s how CDs
work: When you purchase a CD, 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 CD, you receive
the money you originally invested plus any accrued interest. But if
you redeem your CD 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 CDs through local banks, many
brokerage firms now offer CDs. These brokerage firms – known as
“deposit brokers” – can sometimes negotiate a higher rate of
interest for a CD by promising to bring a certain amount of deposits
to the institution. The deposit broker can then offer these
“brokered CDs” to their customers.
At one time, most
CDs paid a fixed interest rate until they reached maturity. But,
like many other products in today’s markets, CDs have become more
complicated. Investors may now choose among variable rate CDs,
long-term CDs, and CDs with special redemption features in the event
the owner dies.
Some long-term,
high-yield CDs have “call” features, meaning that the issuing bank
may choose to terminate – or call – the CD after only one year or
some other fixed period of time. Only the issuing bank may call a
CD, not the investor. For example, a bank might decide to call its
high-yield CDs if interest rates fall. But if you’ve invested in a
long-term CD and interest rates subsequently rise, you’ll be locked
in at the lower rate.
Before you
consider purchasing a CD 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 CD Matures – As simple as this sounds, many
investors fail to confirm the maturity dates for their CDs and are
later shocked to learn that they’ve tied up their money for five,
ten, or even twenty years. Before you purchase a CD, ask to see the
maturity date in writing.
For
Brokered CDs, 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 CD. In
other words, find out where the deposit broker plans to deposit your
money. Also be sure to ask what record-keeping procedures the
deposit broker has in place to assure your CD will have federal
deposit insurance. For more information about federal deposit
insurance, read the FDIC’s publication Your Insured Deposits
or call the FDIC’s Central Call Center at (877) 275-3342 or (877)
ASK-FDIC. For the hearing impaired call 1-800-925-4618
or 1-703-562-2289 (7:00 am to 7:00 pm
Eastern time)
Investigate Any Call Features – Callable CDs give the
issuing bank the right to terminate the CD after a set period of
time, but they do not give you that same right. If the bank
calls or redeems your CD, you should receive the full amount of your
original deposit plus any unpaid accrued interest.
Understand the Difference Between Call Features and Maturity
– Don’t assume that a “federally insured one-year non-callable” CD
matures in one year. If you have any doubt, ask the sales
representative at your bank or brokerage firm to explain the CD’s
call features and to confirm when it matures.
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 CD 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 CD, make sure you
understand when and how the rate can change. Some variable-rate CDs
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 CDs pay interest rates that track the
performance of a specified market index, such as the S &P 500 or the
Dow Jones Industrial Average.
Research
Any Penalties for Early Withdrawal – Be sure to find out
how much you’ll have to pay if you cash in your CD before maturity.
Ask
Whether Your Broker Can Sell Your CD – Some brokered CDs
are issued in the name of the “custodian” or deposit brokers. In
some cases, the deposit broker may advertise that the CD does not
have a prepayment penalty for early withdrawal. In those cases, the
deposit broker will instead try to resell the CD for you if you want
to redeem it before maturity. If interest rates have fallen since
you purchased your CD and demand is high, you may be able to sell
the CD for a profit. But if interest rates have risen, there may be
less demand for your lower-yielding CD. That means you may have to
sell the CD at a discount and lose some of your original
deposit .
Find Out
About Any Additional Features – For example, some CDs offer
a death benefit that allows a CD owner’s heirs to redeem the CD
without penalty when the owner dies.
The bottom-line
question you should always ask yourself is: Does this investment
make sense for me? A high-yield, long-term CD 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.
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