If your savings grow to the point where you have more money than you think you need anytime soon, congratulations! One of the places you can consider depositing some of the balance is a certificate of deposit (CD). A CD is a receipt for a deposit of funds in a financial institution. Like savings accounts and money market accounts, CDs are investments for security.
With a CD, you agree to lend your money to the financial institution for a number of months or years. You can’t touch that money for the specified period of time without being penalized.
Why would a financial institution need you to loan it money? Typically, institutions use the deposits they take in to fund loans or other investments. If an institution primarily issues car loans, for example, it’s apt to pay attractive rates to lure money to four-year or five-year CDs, the typical car-loan term.
Generally, the longer you agree to lend your money, the higher the interest rate you receive. The most popular CDs are for six months, one year, two years, three years, four years, or five years. There is no fee for opening a CD. By depositing the money (a minimum of $500) for the specified amount of time, the financial institution pays you a higher rate of interest than if you put your money in a savings, checking, or money market account that offers immediate access to your money. When your CD matures ( comes due), the institution returns your deposit to you, plus interest. The institution notifies you of your CD’s maturation by mail and usually offers the option to roll the CD over into another CD. When your CD matures, you can call your institution to find out the current rates and roll the money into another CD, or transfer your funds into another type of account. Most institutions give you a grace period, ten days or so, to decide what to do with your money when the CD matures.
At an FDIC-insured financial institution, your investment is guaranteed to be there when the CD matures. Financial advisors say that CDs make the most sense when you know that you can invest your money for one year, after which you’ll need the money for some purchase you expect to make. The main reward of investing in CDs is that you know for sure what your return will amount to and can plan around it, because CD rates are usually set for the term of the certificate. Be sure to check on the interest rate terms, though, because some institutions change their rate weekly. For example, after buying a house in early fall, my friend Mark made plans to have the exterior repainted the following spring (a short-term goal). In October, he received a nice $4,000 bonus from work. Knowing that he might be tempted to spend that money on dinners and CDs (the musical kind), Mark invested that $4,000 in a six-month certificate of deposit with a 4.6% interest rate. When spring rolled around, his CD matured, and he received $4,092. That amount he gained in interest may not sound like a lot, but it’s about twice as much as he would have received had he deposited the money in a typical savings account. And it’s possibly $92 more than he would have had if he had kept the money in his regular, non-interest-bearing checking account.
The major risk is that interest rates can rise sharply before your CD matures. That situation costs you the opportunity to earn more on your money through some other form of investment. The interest rates paid on CDs are contingent on many factors. In general, they tend to mirror the interest rates in the general market. Most bank CDs are tied to the rates paid on treasury notes and treasury bills. (Treasury rates are the rates offered by the Federal Reserve when they issue treasury obligations.) If the two-year treasury note pays a good rate, interest rates on the bank’s CDs tend to be at a good rate, too. It pays to shop around for CD specials to get the best interest rate. Remember to check out the rates at savings and loans and credit unions. Credit unions typically pay up to half of a percentage point higher interest on CDs, whereas savings and loans generally pay more than banks but less than credit unions.
If you want your money back before the end of the CD’s term, you will be heavily penalized, usually with the loss of six months’ worth of interest. A second drawback is that CDs are taxable. Whatever interest you earn, you must pay taxes on at both the federal and state levels. However, assuming that you’re not in a high tax bracket, the taxes shouldn’t be a huge consideration for most people starting out. If rates are low, you may want to purchase shorter-term CDs and wait for rates to rise. This way, you won’t be tying up your funds for long periods of time while rates might be climbing. As another option, some banks might allow you to add money to a CD account at the interest rate of that particular day. The advantage to this method is that if you open the account on a day when the rate is low, you can increase your earnings by adding money at a higher rate, later.
With a CD, you agree to lend your money to the financial institution for a number of months or years. You can’t touch that money for the specified period of time without being penalized.
Why would a financial institution need you to loan it money? Typically, institutions use the deposits they take in to fund loans or other investments. If an institution primarily issues car loans, for example, it’s apt to pay attractive rates to lure money to four-year or five-year CDs, the typical car-loan term.
Generally, the longer you agree to lend your money, the higher the interest rate you receive. The most popular CDs are for six months, one year, two years, three years, four years, or five years. There is no fee for opening a CD. By depositing the money (a minimum of $500) for the specified amount of time, the financial institution pays you a higher rate of interest than if you put your money in a savings, checking, or money market account that offers immediate access to your money. When your CD matures ( comes due), the institution returns your deposit to you, plus interest. The institution notifies you of your CD’s maturation by mail and usually offers the option to roll the CD over into another CD. When your CD matures, you can call your institution to find out the current rates and roll the money into another CD, or transfer your funds into another type of account. Most institutions give you a grace period, ten days or so, to decide what to do with your money when the CD matures.
At an FDIC-insured financial institution, your investment is guaranteed to be there when the CD matures. Financial advisors say that CDs make the most sense when you know that you can invest your money for one year, after which you’ll need the money for some purchase you expect to make. The main reward of investing in CDs is that you know for sure what your return will amount to and can plan around it, because CD rates are usually set for the term of the certificate. Be sure to check on the interest rate terms, though, because some institutions change their rate weekly. For example, after buying a house in early fall, my friend Mark made plans to have the exterior repainted the following spring (a short-term goal). In October, he received a nice $4,000 bonus from work. Knowing that he might be tempted to spend that money on dinners and CDs (the musical kind), Mark invested that $4,000 in a six-month certificate of deposit with a 4.6% interest rate. When spring rolled around, his CD matured, and he received $4,092. That amount he gained in interest may not sound like a lot, but it’s about twice as much as he would have received had he deposited the money in a typical savings account. And it’s possibly $92 more than he would have had if he had kept the money in his regular, non-interest-bearing checking account.
The major risk is that interest rates can rise sharply before your CD matures. That situation costs you the opportunity to earn more on your money through some other form of investment. The interest rates paid on CDs are contingent on many factors. In general, they tend to mirror the interest rates in the general market. Most bank CDs are tied to the rates paid on treasury notes and treasury bills. (Treasury rates are the rates offered by the Federal Reserve when they issue treasury obligations.) If the two-year treasury note pays a good rate, interest rates on the bank’s CDs tend to be at a good rate, too. It pays to shop around for CD specials to get the best interest rate. Remember to check out the rates at savings and loans and credit unions. Credit unions typically pay up to half of a percentage point higher interest on CDs, whereas savings and loans generally pay more than banks but less than credit unions.
If you want your money back before the end of the CD’s term, you will be heavily penalized, usually with the loss of six months’ worth of interest. A second drawback is that CDs are taxable. Whatever interest you earn, you must pay taxes on at both the federal and state levels. However, assuming that you’re not in a high tax bracket, the taxes shouldn’t be a huge consideration for most people starting out. If rates are low, you may want to purchase shorter-term CDs and wait for rates to rise. This way, you won’t be tying up your funds for long periods of time while rates might be climbing. As another option, some banks might allow you to add money to a CD account at the interest rate of that particular day. The advantage to this method is that if you open the account on a day when the rate is low, you can increase your earnings by adding money at a higher rate, later.
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