CDs Tips

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What else should I know about CDs?

CD Facts

Everyone knows you have to compare CD rates in order to get the best deal, but for many consumers that is where all their knowledge of CDs ends. Since an informed consumer is a powerful consumer, here are a few other CD facts you should know:

  1. You can take CD interest generally without penalty. If you take CD interest out when you earn it then it will not compound, but because you aren't touching your principal you can take the interest without a penalty being imposed.
  2. CD interest is taxableãunless it is in an IRA or other qualified account. Even if you do not touch your CD interest you must pay taxes on it unless you allow it to grow in a tax-qualified account (like an IRA).
  3. CDs are FDIC insured. FDIC insurance is only good up to the first $100,000 ($250,000 until 2013) you have at any single bank.
  4. CDs come in many different terms, some as few as 6 months.
  5. CDs can be purchased directly from your local bank or through a broker.

   
Are CDs good for long-term investing?

CDs and Long-term Investing

There are two primary reasons that CDs are not appropriate for long-term investments:

Low Yield
Your yield on any investment is the return you make on your principal. When you compare CD rates you are looking for the rate that will give you the best yield on your investment principal. Since CD rates are so low, they offer a low yield compared to many other investments likes stocks and bonds. When you invest money over a long term, you should be looking for a yield that is comparable to both the length of time you invest the money and the risk tolerance you have. CD rates rarely offer a yield that is high enough.

Interest Rate Risk
The interest rates in CDs do not vary. Once you buy a CD it is for a fixed rate and term so even as interest rates are getting higher or lower in the real world (and in new CD issues) your CD's interest rate will remain the same. If you buy at the wrong time, that could mean you are stuck with a low interest rate that is not competitive with current rates for a very long term.

   
Are CDs good for retirement accounts?

CDs and Retirement

As people edge close and closer to retirement age, they begin to long for fixed, low-risk investments to put their money in. After all, it is much harder to recover from an investment loss experienced at age 65 than one experienced at age 35. At 35, not only do you have time for the market and your investment to rebound but you also have many more years ahead of you to increase your earnings. At 65 you are definitely at a disadvantage.

As you begin to transfer out of high-risk positions in your retirement, it is not a good idea to leave your cash uninvested. Instead, you might consider doing some CD rate comparisons to find an attractive interest rate with a CD term that you feel you can stick with. Remember, you will be penalized if you take money from the principal of your CD before the term is up so be sure to leave enough cash or other highly liquid investments in your retirement account to cover any required minimum distributions (RMDs) you may have or any emergency cash needs you could encounter.

   
Do I need to use a CD rate calculator?

The Usefulness of CD Rates Calculators

When you are looking at CD rates, it can be difficult to visualize the real dollar difference between two interest rates. Because you are not able to see the dollar difference between a 1.5% interest rate and a 2% interest rate you may assume that the rate difference is not a big deal and could lose out on potential growth.

A CD rates calculator can give you the actual calculations on return for each of the interest rates you are comparing so that you get a real understanding of the potential differences. This will help you make an informed decision based on hard numbers rather than assumptions.

Example
For example, let's say you have $10,000 to invest in a 12 month CD. One bank has a 1.5% interest rate and the other has a 2% interest rate and each has interest that compounds monthly. At the end of 12 months you would have earned $151.04 in interest in the 1.5% CD and $201.84 in the 2% CD. That is a difference of more than $50.

   
Do CDs have penalties for early withdrawal?

CD Penalties

While you compare certificate of deposit rates, you must consider the penalties that go along with them. You see, in order to offer a high interest rate, banks and financial institutions expect you to keep your money invested in the certificate of deposit for the entire period you initially agreed to. So if you agree to a 5 year CD with an interest rate of 3%, the bank is only able to give you that 3% because they know they can invest your money on loans for at least 5 years.

If you should decide to take some of your certificate of deposit principal out before the 5-year term ends, then the bank is not going to pay you a 3% return. Instead, they are going to apply a penalty to the funds you take so that your yield is reduced. When you compare certificate of deposit rates, if you look only at the interest rate of the potential certificate of deposit then you are only getting part of the story. Instead, evaluate your potential purchase on both the interest and the penalties as well as your potential ability to leave the money alone.

   
Is there any risk in investing in CDs?

The Interest Rate Risk of CDs

There is no such thing as a risk-free investment. Even something as low-risk as a CD carries with it some risk. This is something you must keep in mind when conducting a CD interest rate comparison.

Interest Rate Risk
The biggest risk associated with CDs is called interest rate risk . Interest rate risk is the general risk that you could get locked in to an unattractive interest rate while outside rates increase. Interest rates offered on CDs are determined by many things including the general interest rate environment (which is driven by the Fed rate) and the credit environment. When interest rates are high and credit is flowing, CD rates will generally be high. But when interest rates are lowered in an effort to get more people borrowing and credit isn't being extended, CD rates will be lower because banks can't make as much money on the cash. If you lock yourself in to a 5-year CD at a low rates and during that term interest rates increase so that new CDs have a much more competitive rates, then you are suffering the effects of interest rate risk.

So keep this risk in mind as you do your CD interest rate comparison and determine how long you want to be locked in to one rate.

   
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