One way to build a safety net and prepare for the future is to use certificates of deposit (CDs). These cash products are generally considered relatively safe ways to preserve your capital, create and emergency fund, or grow wealth (albeit at a snail’s pace). Before you commit to a CD, though, it is important to consider some important points.
Choosing a CD that works best for your circumstances is vital if you want to meet your goals. Here are some suggestions for choosing a CD:
Consider your financial goals:
Look at where you are with your finances, and where you want to be. Do you have a financial plan? Consult your plan and your goals to determine whether a CD can help you reach your goals. Also, consider what role you want cash products, including CDs, to play in your investment portfolio or your emergency fund.
Know the maturity date:
Make sure you are clear on the maturity date. If you plan to use a CD ladder for an emergency fund, you want to make sure your maturity dates line up so that you get access to the money with regularity. If there is a long maturity date, make sure that you are okay with having that money tied up for the length of time in question.
Confirm the interest policy:
You also want to know the interest policy. Fin out what rate you will receive, and whether it is variable, changing with the market. You also want to know how you will be paid interest. Some banks add the interest back into the CD, while others issue interest payments on a regular basis (monthly, quarterly, semi-annually, annually). Also find out whether the payment is issued via electronic funds transfer or by check. Understand whether there are special schedules, steps or bonuses.
Understand early withdrawal:
Know the penalties charged for early withdrawal. Most banks will charge you a penalty if you withdraw money from your CD before it matures. This can be quite a hefty penalty, destroying a good part of your investment if you are not careful. There are some banks that offer no-penalty CDs, but these are few and far between, and the yields are lower.
Know about the call options:
Some CDs come with call options. It is vital to know what sort of call option is on a CD. For instance, if the CD is “non-callable for a year”, that means that for a year, the bank has to leave the CD alone. However, after one year the bank can actually redeem the CD anytime. So, if interest rates fall, the bank can call CD after the “non-callable” period ends, redeeming the principal and unpaid accrued interest to you, and forcing you to get a new CD at a possibly lower rate. However, a call option does not affect the maturity date. You do not have the same privilege to call the CD as the bank does. If you try, before the maturity date, you will be stuck with penalties.
CDs can be a good fit for your financial plan — as long as you understand the policies that go with them. Make sure you double check the fine print, and that you are clear on maturity dates, call options and penalties before committing to a CD.