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Certificate of Deposit (CD) For Risk Adverse Investors?

Posted on Friday, December 21st, 2018 by MarketBeat Staff

Summary - A certificate of deposit (CD) is an investment product that ensures owners the return of their principal, in addition to the interest that they earn on the CD. Because CDs offer a high yield (i.e. better interest rate) than a traditional deposit account or money market account, they can be an attractive investment for investors who will not need access to the cash.

With the proliferation of online banks, many investors can find high-yield CDs with just the click of a mouse. These online banks, such as EverBank, can offer highly competitive interest rates and may even offer a wider variety of products such as step-up CDs, bump-up CDs, or IRA CDs.

Like all investments, a certificate of deposit is not without risk. Most CDs require a minimum deposit that can be $1,000 or more. In fact, the higher the interest rate, the higher the likely minimum initial deposit and the longer maturity period. Although the funds in a CD are ensured by the FDIC, they come with an early withdrawal penalty, that can negate any or all of the interest earned. For this reason, investors should be sure to choose a maturity period that will ensure they can access their money without penalty should they have to withdraw funds.

Introduction

Every investor should have a certain amount of their portfolio set aside as cash. Depending on their risk tolerance and stage in life, the amount of cash could vary substantially. But what does it mean to have cash in your portfolio? As of this writing, savings account rates are still abysmal. And both regular savings accounts and money market accounts have variable interest rate concerns. What could start out being a favorable investment could quickly turn negative.

A third option for investors is a Certificate of Deposit (CD). With a CD, investors get cost certainty in that they are guaranteed a rate of return and in exchange, they are agreeing to keep their funds deposited with a financial institution until the maturity date of the certificate.

This article will break down what investors need to know about a certificate of deposit including the many different types of CDs and a technique that can help investors maximize both the liquidity and return of these investments.

What is a Certificate of Deposit?

A certificate of deposit (CD) is a financial product that allows a financial institution or brokerage firm (typically banks and credit unions) to hold a depositor’s funds until a fixed maturity date in exchange for a fixed rate of return. The essential trade-off is that the buyer of the CD is sacrificing liquidity (i.e. access to their money) for the guarantee of a return of their principal plus all the interest earned at the time of maturity.

This brings to mind two important characteristics of CDs. First, in virtually all cases, the deposits (up to $250,000) have deposit insurance from the FDIC which means, unlike a money market fund, there is no chance of an investor losing their principal balance. Second, because investors are allowing their funds to be tied up for a specific period of time, certificates of deposit will offer competitive interest rates that are higher than the rates found in a traditional savings account or money market account.

One way to think about CDs is that they are, in essence, a promissory note between the seller and the buyer. As the buyer, you are allowing the financial institution to borrow your money for a fixed period of time, known as the maturity period. In return, they are offering you a higher rate of interest on that money.

For their part, banks are eager to sell CDs because they rely on deposits to fund their lending operations. Certificates of deposit provide them with a form of cost certainty because they know they will have those funds until the maturity period ends.

Certificates of deposit are considered small or large depending on the amount invested in them. A small CD is considered one that has a value (initial deposit) of less than $100,000. These CDs will generally require a minimum investment to open. This is generally $500 or $1,000. A large, sometimes called a jumbo CD, is one that has a value (initial deposit) of more than $100,000. These are usually considered negotiable (see below) and have shorter lengths to maturity.

How is interest on a CD calculated?

All interest rates advertised for a CD are based on an annual percentage rate. So a CD paying 3% would mean that an investor who puts $1,000 into a one-year CD would receive $1,000 plus the 3% interest at the end of the first year. Since the interest earned on a certificate of deposit is compound interest, the value of the CD at maturity would depend on how frequently the interest was compounded. Most CDs will compound interest daily or monthly.  This can make a significant difference in the value of the CD at maturity.

Assuming an investor purchased a 12-month $2,000 CD with a 2% interest rate that compounded monthly, the value of the CD would look like this:

Month

Value

1

2,003.33

2

2,006.66

3

2,010

4

2,013.35

5

2016.70

6

2020.06

7

2023.43

8

2026.80

9

2030.18

10

2033.56

11

2036.95

12

2040.34

 

If the investor were to put their money into a product that paid simple interest at maturity the value would be an even $2,040. This starts to show the benefit of compound interest. If the CD were compounded daily, the amount would be higher. You can also see that if the CD was held for five years, the investor would receive even more benefits from compound interest. This is also because lenders will pay out a higher fixed interest rate in return for a longer maturity length.

How do taxes affect a CDs total return?

One of the downsides of owning a CD is that the owner of the CD will have to pay federal and state taxes on the interest that accrues in the CD. The one exception is if they own an IRA CD (explained below). In our example above, assuming the investor purchased the CD in January and it reached in December, they would have received $40.34 in interest on their CD. That amount would have to be recorded on their taxes for that year. What is a further downside is that the interest is calculated as interest income, not as a capital gain. One piece of good news is that the investor will only pay taxes on the interest that was earned for that tax year. If they take out a five-year CD, in the fifth year, they will only pay taxes on the interest accrued in that year, not on any interest accrued in the prior years.

The financial institution that issues the CD will provide the owner with a 1099-INT statement that documents how much interest the CD accrued for that tax year.

Do CDs have a penalty for early withdrawal?

In general, investors can remove money from a CD prior to maturity, but they will have to pay what is called an early withdrawal penalty. This will vary depending on the lending institution and the length of the CD. The penalty is specified when the CD is purchased and is typically equal to an established amount of interest. Although investors should take care to put money into a CD that is truly disposable, there are a couple of occasions where they may need to make a withdrawal.

  1. Financial hardship – None of us can predict the future, and from time to time investors may need money to get through a period of financial hardship such as, perhaps a period of extended unemployment, or an unexpected medical bill.
  2. They want to take advantage of a better rate – Sometimes the owner of a CD may want to take advantage of a better rate of return on another CD. In some cases, the higher interest rate may make it worth it to pay the penalty.

Can a CD ever be traded or exchanged to someone else?

This will depend on whether the CD is negotiable or non-negotiable. The majority of CDs are non-negotiable this means they cannot be bought, sold, transferred or exchanged with another party. However, they can usually be cashed out before their maturity date. Negotiable CDs, on the other hand, can be traded on a secondary market, but they cannot be redeemed early. A negotiable CD is a large or jumbo CD meaning it is issued in at a value of $100,000 or more. And, these CDs are typically short-term meaning that they have maturity dates that range from two weeks to twelve months.

What happens when a CD reaches maturity?

At maturity, investors have two options. The first option is to simply cash out the CD, usually into their existing checking or savings account if the CD is purchased through a bank. The second option is to re-invest the CD into another CD. This allows investors to continue to take advantage of compound interest. It’s also a way to hedge against fluctuating interest rates. A common technique used when re-investing CDs is the concept of laddering CDs.

To create a CD ladder, multiple CDs are purchased at varying maturities. For example, an investor could choose to invest a total of $20,000 evenly into CDs at one-year intervals between one and five years. As each certificate expires, the investor will re-invest the CD into a fixed-rate 5-year CD. In this way, every year they will have a CD expiring, but they will have access to at least $4,000 (+ accrued interest) annually. This chart without interest numbers helps illustrate the concept of a CD ladder.

Buy Today

End of Y1

End of Y2

End of Y3

End of Y4

End of Y5

 End of Y6

1-year CD @ 2.5%

$4,000

$4,000 (+2.5% compounded)
Purchase 5-year CD @ 3%

Interest is compounding

This CD is ready to be re-invested or redeemed

2-year CD @ 2.6%

Interest is compounding

$4,000 (+2.6% compounded)
Purchase 5-year CD @ 3%

Interest is compounding

3-year CD @ 2.7%

Interest is compounding

$4,000 (+2.7% compounded) Purchase 5-year CD @ 3%

Interest is compounding

4-year CD @ 2.85%

Interest is compounding

$4,000 (+2.85% compounded) Purchase 5-year CD @ 3%

Interest is compounding

5-year CD @ 3%

Interest is compounding

$4,000 (+3% compounded) Purchase 5-year CD @ 3%

Interest is compounding

 

How to choose a maturity period for a CD?

The vast majority of CDs range in length from three months to five years. When considering what length is right for an investor, they should consider their personal financial situation for predictable risk. Although the rate of interest is greater for longer-term CDs, investors who want to minimize the risk of withdrawing funds before maturity may want to take out shorter CDs with shorter maturity periods. Also, if an investor feels that interest rates are likely to rise in the near future, they may choose a shorter term so that they can more easily move their money to a product with a higher interest rate.

Understanding Specialty Certificates of Deposit

Understand that CDs are investments and, as such, there are different varieties for investors to choose from:

  • Liquid CDs – As the name implies, the attractive feature of these CDs is liquidity. There is generally a low or no early withdrawal penalty. However, the trade-off is the interest rates are lower and they usually require a larger minimum balance requirement than other fixed-rate CDs. These CDs can be appealing for depositors who are unsure about the direction of interest rates and want the flexibility to move to CDs with higher, more competitive rates, if possible.
  • Bump-Up CDs – These are similar to liquid CDs, in that they offer a lower interest rate and a minimum deposit that can be higher than other fixed-rate CDs. However, the benefit is that owners can automatically switch (or bump up) to a certificate that is paying a higher rate of interest. There is usually a limit to how many times an investor can bump up to a higher rate.
  • Step-Up CDs – These are similar, but not the same as bump-up CDs. Step-up CDs automatically raises the interest rate of the CD on a preset basis. These can be attractive but investors need to compare the blended interest rate with the fixed rate of a CD of the same maturity.
  • IRA CD – These certificates are just fixed-rate CDs, but they are held inside an individual retirement account (IRA). This provides the benefit of tax deferral until the money is withdrawn which is usually done when the investor is in a lower tax bracket. Investors need to consider that the purchase of a CD in an IRA counts against their standard contribution limit, therefore these should be used sparingly or else the overall return of the IRA will be impacted.
  • Brokered CD – this is a CD that is sold through a brokerage account. In some cases, because they are sold online, investors may get a higher rate of return. The tradeoff with a brokered CD is that it may not be FDIC insured. If it’s not, investors should be careful to ensure that the higher interest rate is worth the risk of not having your funds insured. These CDs can also be more difficult to get out of at maturity.

The bottom line on a certificate of deposit

A certificate of deposit (CD) can be an appropriate savings vehicle for investors who have a low-risk tolerance, but a desire to make the cash part of their portfolio work for them. Certificates of deposit act like a promissory note between the institution (usually a bank or credit union) that issues them and the buyer. The buyer agrees to keep his funds with the institution for a fixed range of time (known as the maturity period) and in exchange, the lender offers a higher interest rate than what they would receive in a regular savings account or money market account.

The benefit of a CD is to both parties is cost certainty. For the lender, they can count on the availability of operating funds to conduct their business. For the investor, they have an investment that is FDIC insured and guarantees them a fixed rate of interest that is significantly larger than they could from a savings account.

Having money in a CD will trigger a tax event for an investor. Unless they have a CD that is part of an individual retirement account (IRA), they will have to pay taxes on the interest that they earn during a given tax year.

Once a CD reaches maturity, investors can either simply cash out or they can re-invest the money into another CD. Many investors choose to create a CD ladder that allows them to distribute their initial investment over a series of CDs with varying maturities thus ensuring that they will always have one CD maturing at a certain point.

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