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Thursday, 25th April 2024 |
| Investing in certificates of deposit |
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| An introduction to adding certificates of deposit to your investment portfolio. |
What are certificates of deposit? Certificates of Deposit (CDs) are time deposits - you agree to place your funds on deposit with the bank for a stated period of time. During the term of the CD your funds earn interest at a stated rate or based upon an agreed method of calculating the rate, such as the percentage increase in the stock market.
Because you agree with the bank to keep your funds on deposit for a period of time, Cds may offer you a higher rate of interest than other types of deposit accounts that allow you more immediate access to your funds, such as checking and savings accounts. Generally, the longer you are willing to let the bank keep your funds, the higher the rate you will receive on your CD.
What are the features of cds? All Cds do not have the same features. Banks are free to offer CDs with different maturities (i.e., three months, one year, five years), methods of determining interest and payment features. Banks are not required to permit you to withdraw your funds prior to the CD’s maturity, even if you were to pay a penalty. If early withdrawal is permitted, there are no strict guidelines governing th penalty that a bank may impose. When selecting a CD you should carefully review its terms and conditions.
Interest rate features Fixed rate: Many Cds pay interest at a fixed rate for the term of the CD. The interest may be compounded or simple. Interest may be paid to you periodically during the term of the Cd or at maturity.
Variable rate: CDs may offer rates that change periodically during the CD’s term. With such CDs you need to understand how the interest rate is calculated and how often the rate can be re-set.
CDs that re-set the rate periodically are referred to as ‘floating rate’ CDs because the rate ‘floats’ during the term of the CD. These CDs may re-set the rate at pre-determined intervals against any number of common financial references- Treasury securities, the prime rate or some index. If these indices decline, so will the rate on the CD. The APY will reflect the rate in effect at the time you purchase the CD.
CDs that change to a pre-determined rate at pre-determined times are referred to as ‘step rate’ CDs. These CDs will have an interest rate that is fixed for a period of time and then ‘step up’ or’step down’ to another fixed rate. The steps may occur more than once before the CD matures. The APY on step rate CDs will reflect the total interest to be paid during the life of the CDs, so it will be less than the highest step rate, but more than the lowest step rate.
Contingent rate: The rate on some CDs is determined by the outcome of some event or the performance of a financial index. For example, many banks offer CDs that pay interest linked to the performance of the stock market. You receive the percentage increase in the value of the stock market over a period of time. If the value of the stock market does not increase, you may receive no interest. In many cases, a contingent rate CD will have an APY of 0%. This reflects the fact that the CD has no stated interest rate and the interest rate cannot be determined at the time you purchase the CD.
Zero coupon: Zero coupon Cds are sold at a discount to their face amount and pay the entire face amount at maturity. For example, you may pay $900 for a $1,000 CD and receive the full $1,000 at maturity. At maturity, you will have received $100 in interest.
Redemption features Call features: Some Cds allow the bank to redeem or’call’ the Cd at its sole discretion. These CDs are termed ‘callable CDs.’ On pre-determined dates, the bank can choose to give you your money back (including accrued interest) and cancel the CD. A call provision does not give you the right the redeem the Cd. Call features are typically incorporated in Cds with longer terms and the call features may be combined with other features, such as a step rate.
Typically, the bank will call your Cd when interest rates have declined below the rate on your CD because the bank can attract deposits at a lower rate. If your CD is called you may not be able to reinvest your money at the same rate as the CD that was called. This risk is termed ‘reinvestment risk.’
Callable CDs are sometimes referred to in terms of their maturity and the period during which they cannot be called. For example,’15 year non-call one’ means the CD matures in !% years, but may be called at pre-determined dates or, in some cases, at any time after the first year.
Banks and deposit brokers must inform you that a CD is callable. However, the APY on a callable CD is not required to reflect the call feature. This will be significant if the CD has step rates because the CD could be called before the CD steps to a more favourable rate. In that case you will receive less than the advertised APY. You should be sure you understand both the APY you will receive on the CD if it is held to maturity and the APY you will receive on the CD if it is called.
Early withdrawal: As stated earlier, banks are not required to permit early withdrawal. You should determine whether early withdrawal is permitted and, if so, the amount of the penalty that the bank will impose if you withdraw your funds. If you think you may need your money before the CD matures, you should decide if the penalty is a reasonable amount to pay for the opportunity to get your money early. If not, you should place your money in a shorter term CD or keep it in a different type of account.
Though not required to do so, banks may permit early withdrawal without penalty in certain circumstances, such as your death or incapacity. |
Source: The Bond Market Association
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| Article appeared in the November 2005 issue.
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