Certificate of Deposit Safety

For new investors, any kind of investment may seem unsafe because the amount of information online, in books and on television regarding the wealth of options available is overwhelming. Certificates of deposit are one of the safest ways to invest your money, but the variations in the types of CDs are numerous, and it's important to understand the differences before jumping into an account. With any CD you choose, it's vital to read the fine print so that you understand exactly what to expect over the course of your investment's maturity.

Definition

Certificates of deposit are generally thought of as safe investments for those who don't want to take risks on their money. They are essentially savings accounts with high interest rates, but once you put your money into the account, you have to be willing to keep it there for a specified period of time. Minimum deposits vary by financial institution, so it's wise to contact your bank or credit union to ask about their specific requirements. Withdrawing before the predetermined time usually means you have to pay fees or give up some interest. However, there are a variety of types of CDs to choose from -- some riskier than others.

Safe CDs

The three safest types of CDs are traditional, bump-up and liquid accounts. With these accounts, you understand how much interest you will accrue over the course of your CD's maturation, and there's no possibility of receiving less interest unless you withdraw early. With traditional CDs, you deposit money and accept a specific interest rate, which accumulates over the course of the agreed-upon time period. Bump-up accounts are slightly different, in that you are allowed to take advantage of a higher interest rate if one comes along while you have the CD -- however, the bump-up CDs generally come with lower initial interest rates. Liquid CDs allow you to withdraw money from your account; however, most banks limit the number of withdrawals and may require you to keep a certain minimum balance. For the convenience of accessing your money, liquid CDs usually have lower interest rates than traditional CDs, but still earn higher interest rates than money market and savings accounts.

Riskier CDs

Callable, brokerage, zero-coupon and high-yield CDs are slightly riskier than the previous three CDs, simply because the interest rates may change over time or, in the case of zero-coupon CDs, because you may have to pay taxes on money you don't receive until the account matures. Callable CDs usually have a period during which they are protected from interest rate fluctuations; however, after that period of time they may be "called" and reissued for a lower interest rate. The incentive for choosing a callable CD is that they are often offered at higher interest rates than traditional CDs. Brokerage and high-yield CDs are also generally callable. Brokerage CDs may be offered at higher interest rates because they compete nationally, rather than locally, through brokers rather than banks. It's important to be aware of where your broker is investing your money at all times -- while investments made with FDIC-insured banks are protected up to $100,000, you'll lose any money invested with banks that are not insured. Make sure to request that your investments are made only through FDIC-insured institutions, and get the documentation of the bank's insurance in writing. High-yield CDs may be advertised at very high interest rates, but then be called and reissued at much lower rates. Zero-coupon CDs are those sold at a discount, which grow to face value by the date of maturity. However, with zero-coupon CDs, you are charged taxes on the income you receive on interest, but you don't receive that money until after the CD matures.

Laddering

The biggest drawback to using CDs is that your money is locked into the account for a certain period of time. Investors often alleviate this problem by laddering their CDs, rather than investing all their money in one account. Laddering works by dividing your money up among several accounts with staggered dates of maturity. Let's say you have $15,000 to invest -- you could have three $5,000 accounts that mature at six months, one year and 18 months, respectively. Once the six-month account matures, you may withdraw the money if you need it or roll it over into an 18-month account. By that point, the one year account is down to six months, and the original 18-month account is down to one year. That means that every six months, you can count on accessing your funds if necessary.