Certificates Of Deposit: Bells And Whistles (Part I)
Beyond the basic model, there are CDs with many features. We'll explore some of the various options, beginning with add-on CDs and ending with zero-coupon CDs in the next section. Some of the features mentioned are stand-alone options, while others can be mixed and matched within the same CD.
Investors should conduct their research carefully to identify the features best suited for their needs.
An add-on CD gives investors the opportunity to make additional deposits beyond the deposit required to open a CD account. The new deposits are added to the existing balance and earn the same rate of interest. This can be a particularly attractive feature when interest rates are in decline. If rates fall, new CDs will offer a lower rate of return than existing CDs. Adding money to the old CD provides a better rate of return than what is available in the marketplace. Most financial institutions that offer an add-on feature set a minimum dollar amount for additional deposits. A typical minimum might be $500, for example.
Bear CDs pay an interest rate that fluctuates inversely to the value of an underlying market index. In other words, the interest rate paid on the CD increases as the underlying market index decreases in value. When a bear market is anticipated, investing in a bear CD provides a guaranteed return of the investor's principal and the opportunity to make money as the underlying market index declines. This type of CD is used for two main purposes: speculation and hedging. Speculation involves trying to profit from market movements by purchasing prior to an expected gain or loss. Hedging involves trying to protect assets. If investors hold assets that follow a market index, they may "hedge" by also investing in a bear CD to offset any losses in the market investment.
While traditional CDs are sold through banks and credit unions, brokered CDs are sold through financial advisors and other intermediaries. Much like mortgage brokers, financial advisors and intermediaries have access to a wide range of products offered by a variety of different companies. Investors can compare the rates and terms offered by a variety of providers when researching (or "shopping") for a brokered CD. (Learn how to effortlessly contribute to a CD, read Step Up Your Income With A CD Ladder.)
Unlike CDs purchased through a bank, brokered CDs can be bought and sold in the secondary market just like stocks and bonds, although this exposes investors to the possibility of loss. For example, when investors purchase a CD that is paying 4% interest right before interest rates climb to 4.5%, buyers will not be willing to pay face value for the 4% CD because there are now CDs on the market offering a better rate of return. Some conservative investors use a broker to find the CD that best matches their investment needs so they can hold that CD to maturity.
Brokered CDs come in multiple varieties, some of which are not insured by the FDIC. Before purchasing a brokered CD, investors should determine whether the CD in question is insured. Most large, reputable, national brokerage firms carry only FDIC-insured products, but it is always best to do some research before investing.
Bull CDs pay an interest rate that rises with the value of an underlying market index. In other words, the interest rate paid on the CD increases as the underlying market index increases. This type of CD is most often used by investors looking for a safe investment that also gives them exposure to the stock market. The CD's interest rate does not lose value if the market falls in value because the CD provides a guaranteed minimum rate.
Bump-up CDs give investors the opportunity to raise, or "bump up", the interest rate on their investment if interest rates in the marketplace increase. This is an attractive option when rates are rising. Consider, for example, a situation in which an investor purchases a two-year CD that is paying 3%. Then, six months after the purchase, interest rates rise to 4%. Rather than being stuck at 3% for the next year-and-a-half, the investor can opt to bump up to a higher rate. Some CDs even permit more than one bump.
The trade off on bump-up CDs is that they start out paying a lower initial interest rate than other CDs of similar maturities. If standard two-year CDs are paying an interest rate of 3%, a bump-up CD might offer an initial rate of 2.75%. If rates rise quickly, however, bumping up moves the investment to a higher rate. The ideal situation is having the opportunity to bump up past the initial standard rate far enough that the investment yields more at maturity than a standard CD would have yielded if held the entire term. On the other hand, if interest rates rise slowly or not all, the bump-up CD could earn less than the potential yield of the standard-rate CD held to maturity.
Callable CDs can be redeemed (or "called") by the issuing bank prior to their stated maturity, usually within a given time and at a predetermined call price. Callable CDs are attractive to investors because they pay a higher interest rate than non-callable CDs. A bank adds a call feature to a CD so it does not have to continue paying a high rate if interest rates drop. For example, if a bank issues a traditional CD that pays 4.5% and interest rates fall to a point where the bank could issue the same CD to someone else for only 3.5%, the bank would be paying a 1% higher rate for the duration of the CD. By "calling" the CD, the bank can stop paying the higher rate to the investor and can issue a lower-paying CD to another investor. Callable CDs typically pay a higher rate to compensate the risk investors take that their CD might be called during the term. (To learn more, read Callable CDs: Check The Fine Print.)
Fixed-Rate CDs pay a steady, fixed rate of return over the entire course of their term. Traditional bank-sold CDs are a common example of this type of CD.
The amount of time an investor must wait until he or she can ...
The online market where investors can purchase federal government ...
The return on investment, expressed as a percentage, on the debt ...
A security backed by a pool of debt, often low-rated corporate ...
An interest-bearing account that typically pays a higher interest ...
A type of security whose cash flows come from residential debt ...
Read about the differences between money market accounts and savings accounts, and see why a depositor would elect a money ...
To address this question, let's employ the concept of distance. In the city, a short taxi ride from your hotel to a convention ...
Learn about the ways inflation can harm fixed-income investments. Find out how to monitor the impact of inflation using common ...
Learn about what immediate consumption means for assets. Find out how consumption impacts investing choices and planning ...