It is well known among investors that a sum of money earning a return of 7% will double in about ten years. Current rates on certificates of deposit, however, are nowhere near that level. The national average for a CD with a term of six months is hovering around 0.2%; those willing to lock their funds into a CD for five years can garner an interest rate of slightly more than 1.1% on average.
CD yields are slightly higher because interest is usually compounded, often on a daily basis. As a consequence, the yield on a five-month CD earning 1.1% is 1.131%. On a six-month CD earning only 0.2% interest, however, the rate and yield are functionally the same since the small amount of interest generated has very little time to grow.
Not all certificates of deposit are structured in the same way
The term “CD” usually refers to a traditional certificate of deposit in which consumers can only withdraw money early by paying substantial penalties. In addition, with these instruments consumers are almost never able to add to their initial deposit during the term. The main benefit of a traditional CD is that it pays a fixed interest rate for the entire term, thereby providing a hedge against falling rates.
The “bump-up CD”
A traditional CD, however, puts you at a disadvantage if interest rates rise during the term of the deposit. If you invest in a bump-up CD instead and rates happen to increase, you can elect to receive the higher rate for the rest of your CDs term. Usually, however, a bank will only allow you to “bump” your rate one time; another drawback to the bump-up CD is that it offers a lower initial interest rate than a traditional CD.
The liquid CD
A liquid certificate of deposit offers investors increased access to their funds, thereby eliminating one of the main objections people have to CDs. When a CD is liquid, a consumer can withdraw money without penalty. On the other hand, since you must keep a certain minimum balance in the instrument, you may not be able to withdraw as much as you want. You pay for this flexibility in advance, in a sense, since liquid CDs offer investors lower interest rates than traditional CDs.
The callable CD
The callable CD actually offers a slightly higher interest rate than a traditional CD. There is a catch, however: this kind of CD can be “called” back by the lending institution before its full term has elapsed.
For example, a two-year CD with six months of call protection is guaranteed to carry the stated interest rate for the first six months. During the remaining 18 months, should interest rates fall, the bank is entitled to call back the CD and reissue it at the lower rate. A callable CD, therefore, is only advantageous for the consumer in a rising rate environment.
CD rates have been low for several years at this point, but they may still be a sound investment option. The stock market, after all, is experiencing high levels of volatility with the DJIA frequently gaining or losing hundreds of points in a single session. Meanwhile, the housing market is still lagging years after the “bubble” of the early 2000s burst. CDs, however, provide consumers with a way to invest their funds without risking them.
Category: Personal Finance