June 22, 2024

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Benefits of Having Certificates of Deposit Investments

The economy is up and down. Stocks are up and down. Heck, life is up and down. But, when it comes to investments, there is one vehicle above all others that provides safety and return. Those are just two of the benefits of having certificates of deposit investments.

Up until the FDIC was created in 1933, you really had to have a ton of trust in your bank if you were going to open of a certificate of deposit. Similarly to today, much of the trust had been eroded, and the FDIC was created to guarantee the deposits that the bank held. Up until last year CDs were guaranteed by the federal government up to $100,000. You can actually have far more insured if things are structured properly, but that is an article for another day. However, this last year, Congress passed, and President Bush signed into law a temporary increase to $250,000 that is set to expire 12/31/2009. So the first benefit, unlike your investments in the stock market, mutual funds, ETFs, etc., your principal is backed by the full faith and credit of the US Government.

Another benefit is a return on your investment. Depending on the term of your certificate of deposit, the bank pays you interest. The interest is commonly expressed as the APY (annual percentage yield). If you invest $100,000 and the bank is paying you 3.00{7fcbeda410c9f02a886f83a59a5af911565ec7141a170d397df667872a958d9e} APY for a 1-year CD it is easy to calculate your earnings. Another hidden benefit of CDs, it isn’t tough to figure out what you will earn. You simply take the $100,000 times 0.03, and you’ll earn $3000. There are lots of places on the internet that have on-line calculators as well. If you open up a 5-year CD, you basically multiply the 1-year earnings times five. Another hidden benefit is the power of compounding. With the above example you would actually earn closer to $16,000.

So far, we have indentified four benefits of having certificates of deposit, safety, return, ease, and compounding. Other benefits are sleeping soundly at night, known income, and flexibility of terms. Common CD terms range from 90-Days to 5-years. Some banks offer longer term CDs of 7-years and 10-years and some offer really short-term CDs of 30-Days.

The last benefit is creativity. Because of their popularity, many banks and brokers have come up with creative CDs, such as step-ups. A step-up CD is where the rate changes at different set time periods. For instance a 16-month step-up CD may change its rate every 4-months. Usually, the start rate is a little lower than the average rates for the given term, but the average yield over all is higher. For instance it might start at 2.50{7fcbeda410c9f02a886f83a59a5af911565ec7141a170d397df667872a958d9e} today. And then bump up .50{7fcbeda410c9f02a886f83a59a5af911565ec7141a170d397df667872a958d9e} each increment. You would end up with a 4.00{7fcbeda410c9f02a886f83a59a5af911565ec7141a170d397df667872a958d9e}. Averaging the rates would yield you 3.25{7fcbeda410c9f02a886f83a59a5af911565ec7141a170d397df667872a958d9e}.

Another type of CD is the bump-up. This certificate of deposit gives you the option of bumping the rate a certain number of times during the term if rates rise. Again, the start rate is usually lower than fixed rates for the same term. You have to be careful with these though. I’m seen banks do things like offering the bump-up CD on an odd-term like 33-months and then never adjusting the 33-month CD rate or not offering the term until the original set expires.

Finally, some banks are creating variable rate CDs where the rate is tied to various stock indexes. This allows investors to have their funds safe and insured, but earn higher interest if the indexes rise in their favor. These tend to be fairly complex. With the stock market at current lows, this could be an attractive route, but read all of the details very carefully. If you think of any other benefits of having certificates of deposit, please leave a comment.