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CDs - KOAM TV 7

CDs

Overview

“CD” stands for “certificate of deposit.” The idea is that you lend money to a bank for a set amount of time (7 days is the minimum, there is no maximum) while accruing interest at a higher rate than what you would earn while the money is in savings. Once the time you’ve agreed on has passed (this means the CD has “matured”), you get the money that you originally put in plus the interest that you have earned throughout. Banks do this so they can take your money and loan it to someone else at a higher interest rate, therefore making money on the loan. For example, if the interest rate is on your CDis 5% and they loan that money to someone else at 6%, they are earning 1% on the loan issued to the other person.

You cannot take the money out earlier than the agreed upon term without paying a penalty. There are some CDs that offer a CD line of credit, meaning that the depositor can take out a loan on the money with a much lower interest rate than a regular loan. This is because they bank has the money should you default on the loan.

Since many banks and brokerage firms offer CDs, they are competitive with interest rates. Obviously, as the investor, you want the highest interest rate. High interest rates are good for savers, and bad for those needing loans. While interest rates change as the economy changes (you can also get a CD at a fixed rate), you cannot guarantee the interest the CD earns, but you can guarantee that you will earn interest. While it’s likely that you won’t be able to retire on the interest earned, if you can put the money in a CD for 5 years or so, you have locked that money away assuring that it won’t get swallowed up by other investments or lost to whatever black hole you have that sucks away all your money.

Types of CDs

  • Bullet CDs:
    This are the most common type of CDs. These are CDs with either a fixed or variable interest rate that cannot be called (see Callable CDs below) by the issuer before its maturity date. These are popular because the investor is assured that the money they put in will stay in for the term of the CD.

  • Brokered CDs:
    These are CDs that are sold to a middleman (the brokerage). They are usually more competitive because many brokerage firms are competing against each other, while also competing against other types of investment option. They can be sold before maturity without an interest penalty, but the original principle cannot be guaranteed.

  • Bump Up CD or Step Up CD:
    The buyer has the option to bump up to a higher interest rate once during the duration of the CD. Since this is only an option once, it is a bit of a gamble due to not knowing if the interest rate might go up again, and again. These CDs tend to have lower interest rates since the bank is allowing you to increase your interest rate at any time (although, again, only once during the term of the CD).

  • Callable CDs:
    The issuer (usually brokerages) can redeem (or call) your CD before maturity. This is usually after a minimum of one year from the date of issue and can happen every 6 months after the initial waiting period. The issuer would recall the CD if interest rates drop and they can reissue it at a lower rate. Callable CDs tend to have higher interest rates due to the risk that investors take not knowing when, or if, the CD will be recalled.

Important Factors to Consider

Look at different banks or brokerage firms to get the highest interest rate possible. While that rate isn’t fixed and is susceptible to economic changes, so get it high while you can.

Will you be able to put this money away without needing it during the term of the CD? While CDs earn more interest than a savings account, if you find that you absolutely need the money, you will lose a lot by pulling it out early.

To learn more, read The Pros and Cons of CDs.

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