Banks, and sometimes brokers, issue short-term, interest-bearing certificates called
certificates of deposit (CDs). If you deposit money into a CD, you must leave it there
for a specific number of days to get a stated interest rate (although some CDs have variable rates).
You will receive both principal and interest at maturity. This investment has two advantages: you know how
much will be earned, and you know when the money will be available to you. CDs are popular among people
who like their investments low-risk and straightforward. Many advisors also consider them to be safe
investments suitable for diversifying portfolios.
This short tutorial will take you through the following areas of CDs:
MORE BASIC INFORMATION
Because your money is expected to stay on deposit until maturity, you may be assessed
a penalty if you withdraw your money from it early. Usually, the penalty is three to six month's interest.
Banks sell most CDs. The Federal Deposit Insurance Corporation (FDIC) provides
insurance for them up to $100,000. Brokerage firms also sell CDs and typically look for
ones with the highest rates and make them available to their clients. However, investors
will pay a fee for this service--usually around one percent of the CDs yield. All expenses
should be considered prior to signing up for the CD with the highest stated rate.
Whereas the bank sets most CD rates, some rise with interest rates. These are called
rising rate CDs.
Generally, the more money deposited into the CD and the longer it stays there, the higher
the rate paid. Any interest earned is taxable.
If you see CD returns quoted for both rate and yield, remember that these are two
different things. The rate is what the CD pays. The yield is what the investor receives.
The yield is always higher than the rate because the rate is compounded. This means that
interest is paid on the interest earned. For example, if the rate is 5.51%, the CD may yield about
5.65% instead. Banks may compound interest daily, monthly, quarterly or in some other time frame.
Be sure you understand all the specifics prior to investing.
SMALL SAVINGS CDs
Certificates of deposit for amounts less than $100,000 are called savings CDs.
They were created so that small investors could participate in the CD market. Most of them are
used like savings accounts, although the length of their maturities and amount of money
invested determines their rates. The minimum deposit, the interest payment schedule and
the methods of compounding differ from bank to bank. Be sure to check these factors
carefully before investing.
Numerous individual types of CDs serve different purposes within the category of small
savings CD's. For example, with a minimum deposit of $10,000, you can buy T-rate CDs.
The weekly rates on six-month Treasury bills determine its rates.
NEGOTIABLE CDs
Negotiable certificates of deposit are issued in denominations over $100,000 and sold
on the open market. These CDs are a type of money market instrument. The depositor of
a negotiable CD is allowed to negotiate the interest rate with the bank.
The secondary market is where investors can sell their CDs to other investors before
maturity if they need cash. These CDs must be $1 million or more in value to be traded.
Negotiable CDs have maturities ranging from fourteen days up to more than one year.
Their rates are closely tied to the going rate of Treasury bills. They are the only interest-bearing
money market instruments, and they are considered safe and liquid. They can be quoted
on the NASDAQ, but they must have a minimum maturity of fourteen days.
In addition to the amount of money deposited, certificates of deposit vary according
to other criteria.
OTHER TYPES OF CDs
Here is a partial list of the most popular variations on CDs available to individual
investors.
Credit union shares are negotiable certificates of deposit issued by credit unions.
Stock-index CDs have rates based on the Standard and Poor's 500 Stock Index.
For the period during which the CD is held, the bank takes the average percentage increase in the
S&P 500 level and doubles it, then pays this figure out as interest. Thus, if the S&P 500 grew
by 3.5%, the interest paid would be 7%.
Add-on CDs are those that allow the investor to deposit money into them after they have been set up.
Variable-rate CDs are instruments whose rates move up or down according to changes
in interest rates. They were created to keep up with volatile short-term interest rates.
A third party will set new rate every 30 days.
Discount CDs are sold for less than their face value. When they mature, the investor
receives the face value. The difference between the face value and the discount price
is the interest. For example, a $500,000 CD can be sold for $475,000. When it matures,
the investor will receive $500,000, and the $25,000 difference will be the interest.
This concludes our introduction to certificates of deposit.
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