All you need to know about Certificates of Deposits.

What are CDs?
When you open a CD or a Certificate of Deposit with a bank or an institution you deposit money with them, for a fixed period of time, also known as the term of the CD. A CD also has a defined interest rate. The interest rate is usually quoted in terms of an annual interest rate – meaning a 6 month CD with a rate of 5% would earn 2.5% during its 6 month term. The term is the period in which the CD matures (i.e. you can withdraw your initial deposit without any penalties). Some CDs pay interest every month, whereas others pay interest at maturity.

CDs usually offer a higher interest rate than a savings account, since you are committing to hold money in the bank for the term. There usually are penalties if you withdraw the money before the completion of the term. The penalties differ greatly between banks.

What is the role of a CD in your portfolio?
CDs offer modest return and the interest earned is taxed as ordinary income every year. They are good instruments to earn a higher return on emergency cash and planned short term expenditures - for instance, saving for a down payment on a house that you plan to buy in two years or a car that you intend to purchase next year.

Usually CDs are FDIC insured up to the limit of $100,000 for total deposits with the institution - meaning that the government guarantees the CD if the bank goes under (check with the bank or institution before opening the CD). CDs offer a relatively low return at low risk and are usually *not* good vehicles for long term investments such as retirement savings or your child’s college savings.

What you need to know when opening a CD
A lot of banks offer CDs that have no minimums (e.g. ING direct http://www.ingdirect.com/). I am a big fan of these since they allow you to break up your principal amount across multiple CDs of smaller denominations each. Let’s say you have $10,000 to invest in a CD. In such cases, rather than opening one CD of $10,000, it is may be better to open 10 CDs of $1,000 each (you may choose even smaller amounts than that). This gives you the flexibility to withdraw money and incur penalties on smaller sums, if in the future you need to withdraw money to cover emergency expenditures before the CD matures. Let’s say you need $1800 before the CD matures. If you have multiple CDs of $1000 each, you can cash out two $1,000 CDs and incur an early withdrawal penalty on just those two. If you had one big CD of $10,000, you would have to incur penalty on the entire amount of $10,000.

Breaking up the deposit amount into multiple smaller amounts also has the benefit of allowing you to stagger the terms of the CD. Longer term CDs usually offer a higher interest rate than shorter term CDs (this is not always true). In the above example, you spread the $10,000 in 10 CDs of $1,000 each with maturities of 6, 12, 18, 24, 30, 36, 42, 48, 54, 60 months. When any of your CDs matures, you convert it to another 60 month CD. This ensures that you have a portion of your money maturing every 6 months to cover any unexpected expenses and gradually all your CDs are earning the higher interest rate of a long term 5 year CD. This is also referred to as laddering.

When are CDs not for you?
When you are saving money for goals that are longer term in nature – such as retirement or college savings, you are probably better off with investing your money in a portfolio of stocks and bonds. Also you have to weigh the tradeoff between a savings account and a CD. CD earns a slightly higher interest rate at the cost of locking your money in for the term.

Useful links:
To check the latest rates of interest on CD check out http://www.bankrate.com/.
Some banks offering good CD rates:
1. ING Direct http://www.ingdirect.com/
2. HSBC Direct http://www.hsbcdirect.com/
3. Countrywide http://www.countrywide.com/ (some mortgage companies have started offering great rates to attract cash)