Read the Fine Print When Investing in a Certificate of Deposit

Many people seek low-risk investment options for their hard-earned money, and one popular choice is certificates of deposit (CDs). CDs are attractive to risk-averse investors because they offer a fixed interest rate and are insured by the Federal Deposit Insurance Corporation (FDIC). In recent times, CDs have gained even more popularity due to market volatility, and the advertising of CDs with attractive yields has generated considerable interest.

CDs are often offered by banks and credit unions and are available in various terms ranging from a few months to several years. The longer the term of the CD, generally the higher the interest rate tends to be. This isn't currently the case because short-term interest rates are higher than long-term interest rates. When an investor purchases a CD, they agree to leave their money in the CD for the agreed-upon term, and in exchange, the bank pays them interest on the principal amount.

CD Maturity Date

Always confirm the maturity date of a CD before investing in one. You would be surprised how many people overlook this critical step and may be surprised to find out that their money is tied up for an extended period. Therefore, before investing in a CD, ensure that you have written confirmation of the maturity date.

Maturity date refers to the date when the CD term ends, and the investor is entitled to withdraw their funds or roll them over into a new CD. Maturity dates can vary widely, from a few months to several years. The maturity date can impact the CD rate, with longer-term CDs often offering higher interest rates than shorter-term CDs.

Confirming the maturity date enables you to plan accordingly and avoid penalties associated with early withdrawals. It also allows you to consider other investment opportunities if their CD is maturing soon.

CD Call Features

A callable CD is a type of CD that gives the issuing bank the right to terminate, or "call," the CD after a set period, but you do not have this same option. If CD rates decline, the bank might choose to call the CD, and you will receive their original deposit plus any unpaid accrued interest.

CD rates have been increasing the past year but rates by top out soon if the Federal Reserve stops increasing the fed funds rate. Rest assured, banks were always behind the curve on increasing CD rates but will be out front on reducing CD rates as the Fed reduces the fed funds rate.

A callable CD may limit your ability to lock in a good CD rate for a long time. In the event that the CD is called early, you may need to reinvest your money at a lower CD rate, which could impact their overall investment return.

Investors must weigh the potential benefits of a callable CD against the associated risks. Callable CDs may offer higher interest rates than non-callable CDs. However, the call feature could also result in a lower overall return on investment if the CD is called early.

Variable Rate CDs

When investing in a variable-rate CD, it is essential to understand when and how the CD rate can change. Some variable-rate CDs have a "multi-step" or "bonus rate" structure, where CD rates increase or decrease over time according to a predetermined schedule. Other variable-rate CDs pay interest rates that track the performance of a particular market index, such as the S&P 500 or the Dow Jones Industrial Average.

A multi-step or bonus rate structure allows you to lock in a specific CD rate for a predetermined period, which can be beneficial if CD rates rise. However, it can have the opposite effect if CD rates decline.


CD Rate Compounding Effect

When investing in a CD, it is essential to understand how the bank pays interest. Some banks pay interest daily, monthly, or semi-annually. Daily compounding is the most advantageous, as it allows you to earn interest on your interest more often, resulting in a higher overall return on investment.

For Example, if you deposit $100,000 in a CD with a 5% CD rate that compounds daily, you will earn approximately $28,400 in interest after five years.

Take that same $100,000 and invest it in a CD with a 5% CD rate that compounds semi-annually you will earn approximately $28,270 in interest after five years, which is a lower return compared to daily compounding.

It is crucial to have a clear understanding of a CD's terms and carefully review the disclosure statement before making a purchase. Before investing in a CD, take the time to familiarize yourself with the terms and conditions that govern the CD. Again, careful review of the disclosure statement to understand the CD's fees, interest rate, compounding frequency, maturity date and especially any early withdrawal penalties.

Author: Brian McKay
May 3rd, 2023