Certificates of Deposit

Certificates of deposit (abbreviated to “CDs”) are an extremely popular savings instrument. CD’s are short term, ranging anywhere from one month up to five years. Higher interest rates are accompanied with longer terms or higher minimum balances. Certain certificates of deposit, known as jumbo CDs, have significantly higher interest rates than typical savings vehicles. Unfortunately, they also require a balance that begins around $100,000 US.

Acquiring Certificates of Deposit

Purchasing a certificate of deposit is very simple. You can buy them from most local banks, online banks, or credit unions. Be aware that differing organizations offer different financial rates, and compete for the funds earned from your deposit. Banks use money made from selling certificates of deposit to make other loans and transactions, and then pay you back part of the interest on their loans. They often attempt to out-bid each other by offering slightly higher interest rates, so you should always compare the rates between multiple organizations. Some will be higher than others. You should beware of the conditions of the certificate of deposit. Most CDs are included in the $250,000 per deposit account based insurance. Due to the coverage limit, many of the highest certificates do not have Federal Deposit Insurance Corporation coverage. If they are not covered, the interest rate should be significantly higher as compensation for the risk of principal loss.

Risks and Reward

Like all financial instruments, they have both risks and downsides. Money in a Certificate of Deposit cannot be accessed until the CD reaches its financial maturity. This means you cannot move the money from the certificate of deposit to another saving vehicle or investment. If the rates on savings vehicles rise after you’ve invested, you’re stuck at the lower rates from the date of your CD purchase. If rates fall after your purchase, at maturity you will have the option of buying a lower rate Certificate of Deposit or shifting to other saving formats. Since other savings vehicles usually have lower interest rates than the certificate market rates you may have to choose non-principal safe investments to get similar rates.

Short or Long Term Durations

If a long term and short term certificate have the same interest rate, there is very little reason to buy the long term certificate. Since the money is locked away for the duration of the CD, it’s unwise to choose a longer term certificate with the same or similar rates as a short term certificate. The only exception is when interest rates are expected to decline in the near future. If the interest is lowered and you have a short term certificate of deposit, you will purchase new certificates at lower rates after your current certificates mature. If you purchase long term CDs and interest rates fall, you will earn higher rates for a longer period of time afterwards.

Certificate of Deposit Laddering

An alternative way of handling certificates of deposit is by using an investment technique known as laddering. Laddering also works for any other maturity based savings or investment vehicle. You purchase multiple CDs, waiting until one is about to mature before purchasing another. As an example, purchase a three months maturity certificate. You purchase another three-month maturity certificate after one month and another one month after that. You repeat this pattern constantly. You constantly acquire new certificates after a set period of time. This prevents investing substantial amounts of money when rates are about to rise, but it also prevents investing a large amount of money when rates are about to fall.