Understanding The Costs Of Investment-Grade Cds: Unraveling The Intricacies

A certificate of deposit (CD) is a type of savings account that pays a fixed interest rate on money held for an agreed-upon period of time. CDs are considered a safe, low-risk investment, as they are federally insured and typically provide a guaranteed return. However, this also means that CDs may offer lower returns compared to riskier investments such as stocks and bonds. When investing in CDs, it is important to consider factors such as the interest rate, term length, deposit amount, and early withdrawal penalties. By comparing CD rates and terms from different financial institutions, investors can find the best options for their needs. Additionally, strategies like CD ladders can help maximize returns and provide flexibility in accessing funds. Overall, CDs can be a stable and predictable component of an investment portfolio.

How do you earn interest on a CD?

A certificate of deposit (CD) is a low-risk savings tool that can boost the amount you earn in interest while keeping your money invested in a relatively safe way. CDs are considered low-risk because they are FDIC-insured up to $250,000. They generally allow your savings to grow at a faster rate than they would in a savings account.

CDs have a fixed interest rate and a fixed term length, typically ranging from three months to five years. The interest rate is usually higher than the rates offered on savings accounts. When the term is up (or when the CD matures), you get back the money you deposited (the principal) plus any interest that has accrued.

CDs earn compound interest, meaning that periodically, the interest you earn is added to your principal. Then that new total amount earns interest of its own, and so on. The frequency of compounding can vary, for example, daily, monthly or annually.

The amount of interest earned on a CD depends on several factors:

• CD rate: This factor determines how much your money grows over time.
• CD term: The longer the term, the more interest you can earn.
• Deposit amount: The larger the amount, the more interest you can earn.
• Early withdrawal penalty: Withdrawing money from a CD before the term ends usually incurs a cost, reducing the overall interest earned.

CDs can be considered a good investment for your short-term savings if you’re looking for guaranteed returns with little to no risk.

What are the pros and cons of a CD?

A certificate of deposit (CD) is a type of savings account that allows people to earn interest at a fixed rate, often higher than what's available with traditional savings accounts. CDs are a relatively risk-free way to grow your funds, but they also have some downsides. Here are some pros and cons of investing in CDs to help you decide if it's the right move for you:

Pros of CD investing:

• Safety and security: CDs are insured by the Federal Deposit Insurance Corporation (FDIC) for banks and the National Credit Union Association (NCUA) for credit unions, so your money is protected in case the bank shuts down or goes out of business. The current coverage limit is $250,000 per depositor, per account ownership type, per financial institution.
• Higher interest rates: CDs typically offer higher interest rates and annual percentage yields (APYs) than high-yield savings accounts or money market accounts. The longer the CD term, the higher the interest rate is likely to be.
• Fixed, predictable returns: CD investors can count on fixed-rate CDs to deliver a specific yield at a specific time. Even if interest rates fall in the broader economy, a fixed-rate CD's APY will remain constant for the full term.
• Wide selection of terms and account options: CDs are available in a range of maturities, from one month to 10 years or more, and there are also unique CD types such as no-penalty CDs and bump-up CDs.
• Laddering opportunities: CD laddering is a strategy where you open multiple CDs with different maturity rates, allowing you to take advantage of changing interest rates and create liquidity.

Cons of CD investing:

• Early withdrawal penalty: CD investors typically have to pay a penalty for early withdrawals, which can eat up interest and result in the loss of principal.
• Limited liquidity: CDs offer less liquidity than savings accounts, money market accounts, or checking accounts. Unless you're using a CD laddering strategy or a no-penalty CD, access to your money is restricted until the maturity date.
• Reinvestment risk: When a CD matures, there is a possibility that yields will have dropped, and if you choose to reinvest, it will be at a lower APY.
• Taxes on accrued interest: CD investors will owe taxes on the interest accrued, which can eat into yield and cause cash flow mismatch problems.
• Inflation risk: Locking your money in fixed-rate CDs carries the risk that inflation will erode the purchasing power of your money over time.
• Comparatively low returns: CDs may offer lower returns than riskier asset classes such as stocks, ETFs, and mutual funds.

How do you cash out a CD early?

Cashing out a CD early will usually result in an early withdrawal penalty. This is because CDs are designed to be a safe place to keep your savings, offering more interest than traditional savings accounts, but with less access to your cash. When you open a CD, you agree to lock your money away for a fixed period. If you break that agreement, your bank may charge you a fee.

Federal law states that for a CD to qualify as a time or savings account with a fixed term, there must be a withdrawal penalty if a customer withdraws the money within the first six days of opening the account. The minimum penalty during this time is seven days' interest. Banks often charge larger early withdrawal fees and apply them throughout the CD's term, beyond the first six days.

The size of the penalty varies depending on the bank and the CD term. The longer the CD term, the bigger the penalty. Most banks charge early withdrawal fees based on the annual percentage yield (APY) the CD pays. For example, you might be charged 90 days of interest on the whole CD amount when you close a one-year CD four months early.

If you haven't earned enough interest to pay the penalty, the bank may take the difference from your original deposit.

You can calculate your early withdrawal penalty by multiplying the amount you're withdrawing by the interest rate, divided by the number of days or months in the year, and then multiplying that figure by the number of days or months of interest you're forfeiting.

Here's the formula:

Penalty = Withdrawal Amount (or Balance Amount) x (Interest Rate / Number of Days or Months in the Year) x Number of Days or Months of Interest

For example, let's say you have $5,000 in a five-year CD with a 4% APY. The CD early withdrawal penalty is 150 days' interest, and you're required to withdraw the entire balance. Using the formula, you can calculate that your penalty will be a little over $82.

While cashing out a CD early will usually result in a penalty, there are some ways to avoid or reduce the fee:

• Look for flexible policies: Some banks allow you to withdraw the interest or a portion of your principal before the term ends. On partial withdrawals, you'll only forfeit interest on the amount you withdraw.
• Open a no-penalty CD: No-penalty CDs allow you to withdraw your money without fees, but they usually offer lower interest rates and don't allow partial withdrawals.
• Create a CD ladder: With a CD ladder, you open several CDs with different maturities. When each CD matures, you can reinvest it into a longer-term CD or withdraw your money. This strategy allows you to take advantage of higher interest rates while maintaining flexibility.
• Consider a brokered CD: Brokered CDs are purchased through a third party such as a brokerage. They often offer higher interest rates, longer terms, and no early withdrawal penalties. Instead of withdrawing your deposit and paying a fee, you can sell your brokered CD on the secondary market.
• Ask for a waiver: In some cases, you may be able to get the early withdrawal penalty waived, especially if you're facing a financial emergency or crisis. Banks are permitted to waive penalties in cases of death, disability, or court-determined incompetence, but they're not required to do so by law.

In some situations, it may be worth paying the early withdrawal penalty to access your money:

• Financial emergencies: If you're facing an unexpected expense, such as a car repair or medical bill, it's often better to take the hit and use the money in your CD rather than going into debt or taking out a high-interest loan.
• Higher interest rates: If interest rates have risen significantly since you opened your CD, it may be worth breaking your CD to secure a higher rate. Calculate the potential interest you'd earn in a new CD and compare it to the penalty you'd pay to see if it's worth it.
• Pay off high-interest debt: If you're paying high interest charges on debt, it may be financially beneficial to use your CD money to pay off the debt, even with the early withdrawal penalty.
• Make a down payment: Using your CD funds to make a larger down payment on a major purchase, such as a home or car, could save you money on interest charges in the long run.

How do you build a CD ladder?

A CD ladder is a savings strategy where you spread a lump sum of money across multiple certificates of deposit (CDs) with different maturity dates. This allows you to take advantage of the higher interest rates offered by longer-term CDs while keeping access to your money at short-term intervals.

• Open the initial CDs: Divide your investment, usually evenly, into several CDs of different term lengths with staggered maturity dates. A traditional CD ladder model has five "rungs", with CD terms increasing by one year up to five. For example, if you have £10,000 to invest, you could put £2,000 each into one-year, two-year, three-year, four-year, and five-year CDs.
• Reinvest each CD when it matures: As each CD matures, reinvest that money into a new five-year CD. After five years, your ladder will have five five-year CDs, and one will mature each year. You can also choose to cash out the CDs and use the money for other purposes, depending on your financial needs and goals.

You can decide how much money to deposit in each CD and whether to reinvest in a new CD when each CD matures. The benefits of a CD ladder include increased accessibility to your cash, flexibility, better interest rates, and a reduced risk of missing out on future high rates. However, there are also some downsides, such as multiple maturity dates to track and no guarantee that the rate of return will beat inflation.

What are the different types of CD?

There are several types of CDs, or certificates of deposit, that work in slightly different ways. Here are some of the most common types:

Traditional CD

With a traditional CD, you deposit a fixed amount of money for a specific period of time, usually between six months and five years, and receive a fixed interest rate. You may face a penalty for early withdrawal, but you can cash out the CD at the end of its term or roll it over for another term.

Bump-Up CD

A bump-up CD lets you tell the bank to increase the interest rate on the CD for the remainder of its term if the bank raises its interest rates after you buy.

Callable CD

A callable CD gives you the chance to earn higher interest, but it also comes with a risk. Callable CDs tend to offer higher yields initially, but if interest rates fall, the bank can call back your CD before it matures and reissue it with a lower interest rate.

Equity-Linked CD

Equity-linked CDs are FDIC-insured and tie their rate of return to a stock index, such as the S&P 500. There is no guarantee that you will receive more than the guaranteed payment when it matures.

Foreign Currency CD

Foreign currency CDs are purchased with US dollars but issued in foreign currencies, such as British pounds or euros. Once they mature, they are converted back into dollars. They can be risky due to changing exchange rates and are complicated even for experienced investors.

High-Yield CD

High-yield CDs are usually traditional CDs that offer higher returns. They often require you to commit to a longer term or a larger deposit than traditional CDs.

IRA CD

An IRA CD is held in a tax-advantaged individual retirement account. They are better suited for people nearing retirement than for young investors.

Jumbo CD

Jumbo CDs require a larger deposit than traditional CDs—usually $100,000 or more. They tend to pay only slightly higher returns than traditional CDs, but the higher deposit, over a typical five-year term, can result in a significantly higher payoff.

Liquid or No-Penalty CD

Also known as no-penalty CDs, liquid CDs let you withdraw your money from the CD before the term ends without having to pay a penalty. Both the rate and the yield are typically lower than those of a traditional CD.

Step-Up CD

A step-up CD is similar to a bump-up CD, but with a step-up CD, the bank automatically raises the interest rate at certain times during the term, rather than you having to ask for it.

Zero-Coupon CD

With a zero-coupon CD, you don't receive annual or periodic interest. Instead, you buy the CD at a price below its face value and cash it in for the full value when it matures.

Variable-Rate CD

A variable-rate CD allows the interest rate to fluctuate based on the financial market. This can be good when rates are high, but risky when they are low.

Frequently asked questions