Guest Author - Reshma Vyas
Traditional bank certificates of deposit have always been a popular vehicle to stash savings and offer several distinct advantages such as a guaranteed rate of interest, safety of principal and interest as well as flexibility.
When it comes to selecting an appropriate certificate of deposit, there are a few critical considerations one should take into account such as:
1. Financial goals and time horizon. Certificates of deposit can range from extremely short-term (30 days in some cases) or long-term (5 years). How quickly will you need the money? Is the money essentially a “parking” place for short-term savings. Or is it to serve as part of an emergency cash reserve or to meet long-term savings goals?
2. Income versus savings. Do you need the income from the CD in order to meet your living expenses? Income oriented investors often ladder certificates of deposit in order to maximize the income potential.
3. Interest rate. Is the interest rate fixed or variable? How is the interest calculated? How is the interest credited? Potential purchasers of certificates of deposit should be aware of how changing economic and market developments can affect interest rates. Individuals should strive to stay current with general economic and interest rate trends.
4. Minimum balance requirement. Some financial institutions will allow individuals to open a certificate of deposit with a minimum balance as little as $250 or $500.
5. Terms and conditions. It is absolutely essential to review the terms and conditions presented in the contract including penalties for early withdrawal, deposit limitation, etc.
6. The type of certificate of deposit. Many banks and financial institutions are increasingly offering certificates of deposit that accommodate a wide array of customer needs and interests. There are a wide range of CDs aside from the traditional certificate of deposit including:
a. Brokerage CD. Many banks utilize brokers to sell their certificates of deposit in the open market.
b. Bump-up CD. The bump-up CD provides an opportunity to move up to a higher interest rate during the term. Generally, this is a one-time option.
c. Inflation-Adjusted CD.
d. IRA CD.
e. Jumbo CD. Banks can pay a higher rate of interest to customers who are willing to make larger deposits, generally $100,000. The FDIC insured deposit is $250,000.
f. Liquid CD. The money can be withdrawn without incurring a penalty. However, there may be a minimum balance requirement and terms and conditions may apply to withdrawals. The interest rate may also be lower in comparison to a traditional CD.
g. Variable CD. The interest rate fluctuates as it is tied to a benchmark such as the consumer price index or a stock index.
h. Zero Coupon CD.
7. Verify the certificate of deposit is insured (either FDIC or NCUSIF). In light of current problems within the banking industry, prospective customers should also review the strength and safety ratings of the financial institution in question.
8. Your risk tolerance. Examine your own individual risk tolerance as it relates to safety versus yield. Far too many individuals chase yield without thinking about the consequences of risk in terms of losing all or a portion of their principal and/or interest. Consumers should carefully review the risks associated with both traditional and nontraditional certificates of deposit as well review any and all applicable terms and conditions.
Informational purposes only and not intended as advice.