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Q: How Does a CD Work?

A: Though others may be “music to your ears,” financial CD’s, or Certificates of Deposit, are “receipts” received as proof of “loans” you make to a bank or other financial institution at an agreed-upon rate of interest for an agreed-upon period of time. When the CD matures or reaches its payout date—which can vary from three months to five years or more—you get back your initial deposit plus any accrued interest. The longer you leave the money in the bank, the greater the rate of interest you receive. As with savings accounts, all interest earned is taxable, and the interest is typically paid to you at regular intervals. The rate of return on CD’s is generally higher than you might receive from a passbook savings account, even for CD’s with short terms of maturity, but if you make an early withdrawal from a CD, you will probably be charged an early-withdrawal penalty or forfeit part of the interest earned. Unlike most other investments, CD’s are insured by the FDIC for up to $100,000.  

            What’s in it for the bank or other financial institution that issues the CD? CD’s allow these institutions to “lock in” deposit amounts and payable interest rates so they can make longer-termed fixed investments with assurances that they have the principal amounts needed to make and maintain such investments.
  
            There are a wide variety of CD types available, including:

            Callable, in which the issuer has the right to discontinue or “call” in the CD after a certain amount of time, for instance, after a year. The issuing bank may want to do this if interest rates fall below the rate that your CD pays. When this happens, you receive the full amount of the original deposit plus any interest that has accrued. This does not work the other way around, however; you can’t “call” your low-paying CD if interest rates rise, though you can cash out and most likely take a loss.

            Brokered, where a third party such as a brokerage firm or an independent salesperson, sells these instruments, which typically pay a higher interest rate, but are generally callable. Do some research on your broker before you buy anything. Independent brokers do not have to go through any licensing or certification procedures, and no state or Federal agency examines them. If you have doubts, call your state securities regulator or check with the National Association of Securities Dealers' "Central Registration Depository" at 1-800-289-9999.

            Jumbos, which are normally issued for amounts greater than $ 50,000.

            No Penalty, where the issuer permits you to withdraw your cash as long as you have kept it for a defined period of time.

            Variable Rate CD’s, which let you put in more money over time and may let you make a certain number of actual withdrawals, but whose rates fluctuate.

            The Securities and Exchange Commission (SEC) recommends that you consider these factors before you buy a CD.

1. Know When It Matures. Make sure you are clear on this so that you know how long you will be tying up your cash. If you are near retirement, for instance, you won’t want to put a large sum of money into a 15- or 20-year CD. Choose one with a shorter maturity.

2. Consider the Source. If you buy a CD from a broker, know who issued it, or where the broker plans to deposit the money, so that you don’t exceed the $100,000 FDIC insurance limitation for any one financial institution for any single depositor.

            Ask the broker to list all of the owners, as well as all of the issuers of the CD. How many of these there are may determine how the broker will resell it if you wish to redeem it before the maturity date. If a bank issued the CD and you are the sole owner, you may be able to simply pay an early withdrawal penalty to get your money back. But if you own it jointly with other customers, your broker will have to find a buyer to pick up your share. Prevailing interest rates at the time that you wish to have your money back may decide whether you make a profit or take a loss. If you have to sell the CD at a discount, because it carries a low-interest rate in a high-interest market, you may end up losing some of your original deposit.

3. Understand the Fine Print. Make certain that you understand the CD’s “call” features, if any, and other limitations. For instance, a "Federally insured one-year non-callable" CD doesn’t mature in one year, though it sounds like it does. That only means that the bank can’t call the CD during the first year. It may actually mature in 15 years. 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 for you, in writing, when it will mature.

4. Know What the Interest Rate Is. Also, know how it is calculated, and what the limitations and penalties (such as early withdrawal) are. Get all of this in writing.  Be sure to ask whether the interest rate is subject to change and when and under what conditions that might happen.

            The bottom line is that, in many situations, buying a CD is a safe way for investors to add balance and stability to their portfolio. But it is imperative that potential investors understand the rules about how long they must keep it, how much they will be paid, what happens if they need their money early, and what they risk if rates rise above the ones they’ve locked in.

Answer provided by the staff of MAKING BREAD.

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