By Bill Broich
Certificates of Deposit are offered by Banks over a specified period of time with fixed or variable interest rates, depending on the time frame selected and amount invested.
The average consumer may not be aware of some more attractive CD terms as they are typically reserved for large investors and therefore offered to the bank’s wealthiest clients. Some types of CDs are not offered directly by an issuing bank but are made available through Financial Professionals licensed to sell the specific CD instrument in question. That is why investigating the Certificate of Deposit alternatives with a Financial Professional is one of the most important fact-finding missions a conservative investor can engage in.
Traditional CDs: Traditional Certificates of Deposit are sold directly by banks to the general public. The purchaser agrees to hold their funds for a specified period of time with the bank in order to attain a fixed return on their investment when the time period ends, usually referred to as the Certificate’s “Maturity Date.”
Time periods vary from 3, 6, or 9 months to 1, 3, 5, and even 7 years, and longer time commitments on the part of the investor will typically be rewarded by higher interest rates from the bank. These interest rates are generally higher than a savings account rate, but compared to non-FDIC insured investments they tend to be lower.
If the depositor wants to withdraw funds prior to the maturity date, penalties are generally applied and this is pretty much the only way you can lose principal with a traditional CD investment.
Brokered CDs: Brokered Certificates of Deposit are sold through Securities Broker Dealers and Deposit Brokers rather than directly through the issuing bank. Brokers purchase the CD from the issuing bank on the investor’s behalf.
Brokered CDS will generally pay out at a higher rate and are more liquid, however even though they can easily be sold to another buyer prior to maturity, the full return on principal is only guaranteed if the brokered CD is held to maturity. If an investor needs to sell before the maturity date, rather than penalties they will be worrying about the value of the product on the open market, so premature sales could still eat into the principal.
The current market values of Brokered Certificates of Deposit are published monthly, so investors are easily able to compare their principal to the market value and calculate the effect of an early sale on their principal investment.
Typically, there is no certificate issued for Brokered CDs. They are bought and sold on a “book entry” basis, meaning that the broker holds the CD in a custodial account for the depositor, which is a standard practice in the securities industry. Many banks are moving into this process with their traditional CDs as well.
Market Linked, or Structured CDs: Market Linked Certificates of Deposit, also referred to as Structured Certificates of Deposit, are a Brokered type of CD offering the safety of FDIC insurance with more attractive interest rates than traditional CDs. They usually pay both a guaranteed interest rate and a variable interest rate, which is tied to a market vehicle such as stocks, bonds, commodities, or indices. Conservative investors find these very attractive investments as the FDIC insurance minimizes risk to principal and the higher interest potential greatly reduces risk to losses due to inflation.
Deposit Brokers have been selling Market Linked CDs (MLCDs) in the United States since Chase Bank introduced them in 1987, but they were designed for wealthier investors and were out of reach to average investors. While today’s MLCDs are available for a minimum deposit of $1000.00, many brokers may require a higher account size.
In today’s low-interest rate environment, Market Linked CDs have increased in popularity as they are designed to return 3 to 4 percent more than a Traditional Certificate of Deposit.
Bump-Up CDs: Bump-Up Certificates of Deposit offer a lower initial interest rate than traditional CDs to investors but provide them with a one time option to “bump up” their rate if interest rates rise during the CD term.
Bump-Up Certificates of Deposit are great for those times when interest rates are rising and rates for CD investment could increase dramatically over the maturity period. The longer a maturity period is, even in a low interest rate climate like we are currently experiencing, the more attractive this type of CD becomes.
Step Rate CDs: Step Rate Certificates of Deposit are designed to “step” up or down to a predetermined rate at a certain point in the term of the CD based on specific circumstances.
There may be multiple step points established within the term of the CD, so the overall interest earned is an average of all the rates over the term of the CD. This type of system is a good compromise for banks and investors navigating extreme interest rate volatility – not appropriate in a stable or flat environment.
Callable CDs: Callable Certificates of Deposit are offered at higher than traditional rates to investors with the bank retaining the option to “call” the CD after a specified period of time.
If interest rates drop, banks will “call” the CD so they do not lose money on the deal, but they offer investors a premium interest rate for the privilege.
Zero Coupon CDs: Zero Coupon Certificates of Deposit, like a Zero Coupon Bond, makes no interest payments until the maturity date and are sold for a discount on their face value maturity date. For example, a $75,000 Certificate over a 7 year maturity rate may be purchased at a deep $50,000 discount on the face value. These Certificates are usually brokered so you will have to find a licensed professional to assist you.
And beware: your income may be taxed annually as it is earned even though you will not receive it until your maturity date. Also, these Certificates are often callable.