In the current economic climate, many people are looking around very carefully for the best place to invest their hard-earned cash. One option is to use a certificate of deposit (CD).
A CD is, fundamentally, a promissory note issued by a bank that entitles the investor to receive interest on a financial deposit. However, this promissory note is not a piece of paper, but a type of account that is set up under particular terms. In a basic CD, those terms are likely to comprise the amount deposited; the interest rate to be paid and the times at which these payments are to be made, and the duration of the account – CDs are for a fixed term. The investor gives the deposit to the bank, for the length of time specified, during which period the bank pays them a pre-determined rate of interest.
Since the CD is a fixed term arrangement, there are usually penalties for early withdrawals, and in general the interest rate rises with the amount invested and the length of term, although there are exceptions to these ‘rules’, as will be explained shortly.
While this is an explanation of the basic (and most common) form of CD, there are other forms of CD, add-ons and options around. These include:
- Ability to add to the initial deposit during the CD’s duration. This has the obvious advantage of creating a larger deposit and therefore a larger amount paid in interest. It is a particularly helpful option when interest rates are falling.
- Bear CDs, in which the interest rate paid varies inversely with a market index.
- Bull CDs, whereby the interest rate paid rises with the value of a market index.
- Bump-up CDs, which are CDs offering investors the opportunity to raise the interest rate during the term, subject to conditions (the number of ‘bumps’ allowed varies by provider).
- Callable CDs – these allow the bank to recall the agreement at a predetermined price, but pay a higher rate of interest as a result.
- Index-linked CDs, providing the chance to gain returns similar to those yielded by major market indexes.
As with most products, the fine detail will vary by provider, so it is definitely worthwhile to shop around for the best terms and CD rates. Buyers should, however, be aware that many CDs have a ‘rollover’ clause, which entitles the bank to reinvest the money on the investor’s behalf, unless the investor acts quickly (within a given time period), at the end of the initial term.
Used thoughtfully, CDs can be a safe and productive investment, and as we have seen, various options are available to ensure that the product fits the investor. However, a CD is not a conventional bank account, so it is up to the investor to do a little forward planning and research to make sure that they get precisely the CD that best suits them.