Category Index: CDs
These articles describe certificates of deposits.

  •  Basics

A CD in the world of personal finance is not a compact disc but a certificate of deposit. You buy a CD from a bank or savings & loan for some amount of money, and the bank promises to pay you a fixed interest rate on that money for a fixed term. For example, you might buy a 30-month CD paying 3% in the amount of $5,000. A bank may have a minimum amount for issuing CDs like $1,000, but there is usually no requirement to buy a CD with an even amount. Interest earned by a CD may be paid monthly, quarterly, annually, or when the CD matures. Interest paid during the CD's term is paid by check or deposited to another account; it is never added to the amount of the CD (like in a savings account), because the CD amount is fixed.

After you have purchased a CD, you can always redeem it before the stated maturity date. However, if you cash out early, the bank will impose a penalty in the amount of 3 or 6-months of interest payments, depending on the term. This "penalty for early withdrawal" is due whether any interest was paid or not.

As the name implies, a CD is usually a piece of paper (the certificate) that states the interest rate and term (actually the maturity date). Because CDs are issued by banks, a CD for less than $100,000 is insured by the government (probably the FDIC program), so the investment is essentially risk-free.

Some CDs can be bought and sold much like a stock or bond. If you buy a CD through a brokerage house, you may be able to re-sell the CD through them to avoid paying an early withdrawal penalty. These CDs usually have significant minimum investment amounts (like $5,000) and require round numbers (like multiples of 1,000).

      •Market Index Linked

A market index linked CD (MILC) is a combination of a CD and a stock-market investment. These instruments seek to add the possibility of great returns to the security of CDs. They do this by pegging the interest rate paid by the CD to the performance of some stock-market index (i.e., they are linked to a market index). The term on these instrument is usually around 5 years.

Like a conventional CD, the principal is fully insured by the federal government, so an investor is guaranteed to receive 100% of the original investment if the CD is held to maturity. Early withdrawal is possible, but frequently constrained to certain dates each year. Further, an investor is not guaranteed to receive 100% of the initial investment if withdrawn early.

All interest is paid when the CD matures. However, there is no guarantee that any interest will be paid. So there is very little chance an investor will do very well, but there is a reasonable chance of doing better than a conventional fixed-rate CD.

These notes have a quirky tax treatment. Although they pay no interest annually, if the CD is held in a regular account, an investor must nonetheless declare income from a market index linked CD every year. So you're probably asking, the thing paid me nothing, what am I declaring!? The amount to declare is based on the amount a comparable, conventional CD of the same term would pay, based on information in the MILC. These declared payments are added to the cost basis of the CD and the whole mess is reconciled when the CD matures. Investors can avoid this hassle by holding this instrument in a tax-deferred account such as an IRA.

Saving versus Investing

It is a common misconception that the terms "Saving" and "Investing" are synonymous with each other - the truth of the matter is that they are vastly different animals for vastly different purposes. Getting a hold of the difference between saving and investing is the key to managing your money. It will help you make more informed choices about financial requirements and needs and actually prevent the unnecessary loss of wealth.

Saving

Generally, "saving" can be best defined as a way of seeking to preserve the assets that you have built up over time. The problem is that most people don't realize that you can actually lose money in various conservative saving vehicles. This happens as a result of taxes and inflation.

When saving money, the primary emphasis is on the stability of the
principal rather than return potential. Psychologically, the appealing feature of saving money is that you are given certain guarantees such as the fact that you're balance will never go below the principle and that you will get a steady, predictable interest rate. To most people, it seems like there are low risks associated with savings. While it is true that savings accounts are more predictable and guaranteed to preserve your principle, it doesn't follow that they are less risky, especially over longer periods of time.

Savers usually store money in low-volatility vehicles like bank savings and checking accounts, certificates of deposit (CDs) and bank money market accounts. The non-volatile nature of these options offer relatively low potentials for return but the overwhelming benefit for them is that the principal is kept safe while interests, however low, are pretty much guaranteed. For money that is needed in the short term, savings are probably the best option.

It is important to remember that this fairly small return potential may not even be able to keep up with the inflation rate and is still subject to taxes. This can actually result in a loss of overall purchasing power for your money, despite what appears to be a slight gain.

As the cost of living increases, you have no choice but to buy goods and services with more money. This happens because inflation results in a loss of value for your money and it makes the task of meeting your financial goals that much more difficult. This means the money pie you are dividing is getting smaller and smaller portions. Your money must be able to grow faster than inflation if you are to achieve your long-term financial objectives.

Investing

Investing is the key to meeting your long-term financial goals. The key ideas behind investing are production and growth. By investing, you are putting your money to work to produce goods and services that will in turn make profit.

To many, investing seems to involve greater risk to the principal compared to saving, and it does over the short time. Investing is less predictable and more volatile in the short run. However, it also offers greater monetary rewards in the form of higher return potential and an overall increase in purchasing power.

Most available investments like bonds, stocks, and mutual funds fluctuate in value. The reasons for this fluctuation vary. In the short terms, the fluctuations often reflect emotion and psychological reactions rather than the real value of the securities. Because of this, a key for common sense investing is to not be swayed by group-think.

Investors must be willing and able to tolerate the ups and downs of the market as well as fully understand that there is the possibility that they may lose the principal if their investments decline in value. However, such loss of principal can reliably be avoided by making wise decisions and the trade-off for short-term uncertainty is the possibility of much greater wealth. It also turns out that the risks involved in investing virtually disappear when doing a long term analysis. Indeed, the greater long-term risk may be with saving vehicles such as CDs and Savings Accounts. This is because historically, equity and bond investing has offered better inflation protection compared to low-risk savings instruments.

In other words: over long periods of time (greater than three years) there is good historical evidence that investing your money is less risky than saving it, when the single criteria is the purchasing power of your initial investment. Surprising, isn't it!

Should you invest your money or save it? The answer to this question will depend mainly on you and your goals. Determine your financial goals, how much you have accumulated and still need to fund your goals, your time frame and your comfort level, keeping in mind the difference between short and long-term risk. If you need your money within three years, then it is probably best to save it. But if you want to build wealth over the long-haul, the only real solution is to invest.