Certificates of Deposit

By: Source: AARP.org Date Posted: 2002-10-08 14:48:31

A certificate of deposit, or CD, is a special type of deposit account that typically offers a higher rate of interest than regular savings accounts. When you invest in a CD, you lock in your savings for a particular length of time, generally three months to five years. If you withdraw your funds early, you pay a penalty. Like savings accounts, CDs are protected by federal deposit insurance up to $100,000, which makes them relatively safe investments.

You can purchase a CD through a bank or thrift institution. In the last few years, many brokerage firms have also begun offering CDs. Brokerage firms buy their CDs through a bank and then resell them to you. These firms can sometimes negotiate a higher rate of interest for a CD by promising to bring a certain number of deposits to a particular banking institution.

Before you invest in the Certificate of Deposit, ask these questions:

When does the CD mature?

Each CD has a maturity date, which is the date you can withdraw your money without paying a penalty. Make sure you receive a written document that tells you the length of time your money will be locked away in your CD. Some CDs can tie your money up for as long as 10 or 20 years.

Does the Federal Deposit Insurance Corporation (FDIC) insure the CD?

Make sure the FDIC insures the bank that issues your CD. This will protect your CD account from losses up to $100,000. If you are buying your CD through a brokerage firm, make sure the bank that issued the CD to the broker has FDIC insurance.

Does the CD have any "call" features?

As mentioned earlier, you can only receive your money from a CD when the CD matures, unless you want to pay a penalty. However, if the CD has a call feature, the issuing bank has the right to terminate the CD before the maturity date. If a bank "calls" your CD, you should receive the full amount of your deposit, plus any unpaid accrued interest. However, you will lose any interest that might have accrued between the call date and the maturity date.

What is the interest rate?

You should receive a document that tells you a CD's interest rate. Find out if your interest will be paid every month or twice each year.

What is the penalty for early withdrawal?

Be sure to find out what it will cost to cash in your CD before it matures. Most banks charge you an early-withdrawal fee. If you get the CD from a broker, you may be told that there is no early-withdrawal penalty. Don't let this make you complacent about cashing in your CD early. Even though you won't pay an early-withdrawal fee, you could still lose money by cashing a CD early.

Here's how:

If you buy a CD through a brokerage firm and cash it before it matures, the broker may try and sell the CD to another investor. This arrangement will work in your favor if interest rates are lower when you cash your CD than they were when you bought it. But if interest rates are higher, your broker will probably try to sell your CD at a discount. This means you'll lose money. In fact, the money you lose could be greater than the early-withdrawal penalty you'd pay if you had purchased the CD through a bank. You could even lose an amount equal to your original deposit.

For More Information

Federal Deposit Insurance Corporation (FDIC)

The Fall 2000 issue of ‘FDIC Consumer News’ features an article that discusses what to consider when buying a CD through a broker rather than a bank.

URL: www.fdic.gov/consumers/consumer/
news/cnfall00/BankCD.html

Securities and Exchange Commission

The SEC has published a fact sheet called ‘Certificates of Deposit: Tips for Investors.’ This brochure is available to read online. It presents tips that can help you figure out which CD features make sense for you. It also includes a list of banking regulators that you can call if you have a complaint.

URL: www.sec.gov/investor/pubs/certific.htm