Market volatility, combined with guaranteed returns, makes many investors buy CDs as a way to "protect" their money.
But CD investments are not always the best choice for protecting your money, especially when interest rates are low for long periods of time.
Over the past decade, financial "innovations" led to the introduction of variable interest rate CDs, as well as CDs with so-called special features (for more detailed information, see the investment choices section below).
By investing in CDs, you are investing a fixed amount of money for set period of time in exchange for regular interest payments.
When the CD matures, you receive your original investment and the accrued interest.
If you choose to close your CD and take back your cash before the maturity date, you may have to pay an early withdrawal penalty.
Be sure to ask how often the bank pays interest (for example, monthly, semi-annually, or upon maturity) and confirm how your interest will be paid (by check, an electronic transfer of funds, etc.).
One of the major benefits of CD investments verses other types of investments is that most CDs provide the added benefit of federal deposit insurance.
Safe Investing Tip:
Federal deposit insurance is limited to a total, aggregate amount for each depositor in a particular bank or institution. Buying CDs through a bank or broker where you already have accounts/deposits may put you at risk of not being fully insured!
This is especially true during bear markets, or when asset prices are falling (i.e. deflation).
Certifications of deposit can be a good choice if you have money that you don't need in the next year or two.
In exchange for locking up your money for a fixed period of time, you usually get a slightly higher interest rate (verses a standard savings or interest-bearing checking account) as compensation.
Make sure you know the maturity date, so you can avoid being shocked to learn that your money is tied up for five, ten, or even twenty years.
The reason this is important is due to compounding over time. An example of compound interest rates can be found using the link in this sentence.
The primary risk for people investing in CDs is inflation. Inflation will decrease your return over time, which becomes a greater concern as the duration of your CD increases.
During periods of growth, inflation a big risk for the so-called "cash equivalent" asset class (any asset that relies on interest rate as the primary source of returns).
For example, if interest rates are lowered to help the economy, purchasing long term CDs will lock in the lowered interest rates. This will increase potential losses from inflation.
If inflation increases rapidly, even short-term CDs can end up losing money because you are locked into an interest rate that is lower than the rate of inflation.
You can learn more about inflation and what to look out for in my page "The 3 Causes of Inflation".
And don't forget the tax on interest. You'll have to report any return from CDs on your annual taxes, and that will drop your returns as well.
The bottom line is that even though the interest rate may be higher than the rate of inflation, you might loss money overall due to a loss from inflation and taxes combined.
Variable Rate CDsIf you’re intrigued by the concept of investing in a variable-rate CD, make sure you understand when and how the rate can change.
Some variable-rate CDs feature a "multi-step" or "bonus rate" structure in which interest rates increase or decrease over time according to a pre-set schedule.
Other variable-rate CDs pay interest rates that track the performance of a specific market index, such as the S&P 500 or the Dow Jones Industrial Average.
Foreign Currency CDsCD investments can also be based on non-US currencies. This is a way to hedge against a loss of purchasing power, or devaluing of the US dollar (e.g. you think the Euro will rise in value compared to the US dollar). Keep in mind that these investments are NOT FDIC insured.
Everbank is one company that offers investment instruments based on non-US currencies. Click here to see Foreign Currency CDs from Everbank.
Callable CDsCD investments that are callable is similar to investing in callable bonds. The issuing bank can "call" or close the CD after a fixed period of time. This means that your ability to lock in an interest rate (particularly a high one) is limited if the CD is callable.
For example, if you lock in a callable CD at a high interest rate, and then interest rates are lowered, a bank may call the CD to save money in the long term.
Also, keep in mind that there is a different between a CD’s call period and the maturity date. A CD investment may be callable after a year (one-year non-callable), but have a maturity of 5 years!
Brokered CDsInvesting in brokered CDs is more complex and carries more risks than investing in CDs offered directly by banks.
Brokered CDs can offer better interest rates than those of your local bank. But be sure to perform background research, as there are no licensing or certification requirements needed to sell brokered CDs.
Sometimes brokered CDs have more than one owner; its sort of like the CD broker sells pieces of a CD to a bunch of different people. This may affect your ability to get FDIC insurance (is your portion of the CD covered?).
If you want to sell, you may be responsible for finding a buyer for your portion (in the event you need to sell before maturity). Not to mention that you will lose some of your original investment.
Investment brokers and independent salespeople, also called "deposit brokers", offer brokered CDs as an investment option.
In addition to outstanding personal budgeting tools (Check out the Mint Manual if you want help getting started with Mint), Mint.com has an easy to use tool for finding online CDs from various brokers. Click here to try the Mint.com CD search tool.