Choosing a Certificate of Deposit Depends on More than Just the CD Rate
August 26, 2009
Choosing a Certificate of Deposit--with Help from the SEC
As the U.S. economy shows signs of strengthening, people are beginning to recover their confidence in the U.S. financial system. This confidence is deserved--lost in the gloom and doom headlines of last fall and winter was the fact that the vast majority of U.S. banks were perfectly healthy, and that in any case most depositors were well protected by FDIC insurance. Protecting your deposits generally isn't so much a matter of bank solvency as it is of making sound decisions when you choose a bank account or product. To help people who are thinking of investing in a certificate of deposit, the Securities and Exchange Commission (SEC) offers several tips for CD shoppers.
Finding the best CD rates is important, but as the SEC points out, it is only one of the steps you should take when buying a CD. Here are other considerations:
- Your financial goals.You should not invest in any financial product unless you understand how it fits into your overall financial plan. This can be as simple as making sure you aren't tying your money up beyond the time when you'll start to need it, or as complex as assembling a diversified portfolio. CDs can certainly play a role, but before you commit, you should understand how that role relates to your goals.
- Maturity date. Be sure the maturity date is confirmed in writing, so you are not tying up money for longer than you think. If the maturity date is beyond 2013, remember that the limit on FDIC insurance is scheduled to revert from $250,000 back to $100,000 at that point.
- Call features. Some CDs are "callable," which means the bank can effectively cancel the CD prior to the maturity date. Why would a bank do this? Most likely, it would happen if market interest rates fell significantly below your CD's interest rate. Why would the bank continue paying that higher CD interest rate when it can effectively reset the CD at a lower rate? Be advised, then, that callable CDs negate some of the advantages of investing in a CD, because they do not necessarily lock in the interest rate for the term of the CD.
- Interest treatment. You should receive a document that confirms what the CD interest rate is, whether it is fixed or variable, how often interest is paid, and how those payments will be handled.
- Variable interest rate features. If you invest in a variable rate CD, you need to understand what triggers a resetting of the CD rate, how this is calculated, and how often this may occur. Be advised that figuring out all the possibilities which determine the value of a variable rate CD is much more complex than for a fixed rate CD.
- Early withdrawal penalties. Even if you don't intend to withdraw your money early, it is worth knowing what the penalties would be. The lower the penalties relative to the CD interest rate, the more flexibility you can maintain.
Certificates of deposit are considered very conservative investments, and they generally are. However, conservative does not necessarily mean simple, and there are features which can significantly change the risk profile of a CD.
Source:
Securities Exchange Commission: http://www.sec.gov/investor/pubs/certific.htm
