December 14th, 2008 1:55 PM by Ron Mastrodonato
Risk: CDs are considered safe investments. However, they do carry reinvestment risk -- the risk that when interest rates fall, investors will earn less when they reinvest principal and interest in new CDs with lower rates. Consider laddering CDs -- investing money in CDs of varying terms -- so that all your money isn't tied up in one instrument for a long time. Learn more about CD laddering in Bankrate's Investing Basics.
Although CD returns often are higher than those of traditional savings accounts, it's important to note that inflation and taxes could significantly erode the purchasing power of your money.
Liquidity: CDs aren't as liquid as savings accounts or money market accounts because you tie up your money until the CD reaches maturity -- often for months or years. It's possible to get at your money sooner, but generally you'll pay a penalty.
Pros and cons: CDs provide interest income with relatively low risk and are insured for up to $250,000 by the Federal Deposit Insurance Corp., or FDIC. (CDs purchased at most credit unions are insured by the National Credit Union Administration, or NCUA.) If you try to cash out your CD prior to maturity, you will incur a penalty, such as the loss of interest for a quarter. Federal law requires a minimum penalty of at least seven days' simple interest on amounts withdrawn within the first six days after deposit. The law doesn't set a maximum penalty, so banks can charge as much as they want. Another downside: Earned interest is subject to income tax.
Where to find them: You can purchase CDs at banks, credit unions and brokerage firms.
Caveats: Things could get complicated if you buy a CD through a broker and the bank listed on the CD fails. You may have to wait until the FDIC sorts through broker records, which can be a time-consuming process, before you get your money back. Further, the FDIC insures deposits only up to $250,000. If you have more than $250,000 invested in a CD, the FDIC may provide you with a receivership certificate for the uninsured amount, but you get no guarantee that those funds will be reimbursed.
Words of caution: "If you have a little more time to tie up your money and possibly want a little higher return (than a savings account), you might want to go into CDs, ladder a portfolio and divide your money up among several maturities of CDs. Then, just keep replenishing the ladder every time one matures. CDs will give you a little higher rate than your bank accounts, and generally, the longer you put the money away for, the higher the rate will be. Overall, people really should be investing with goals in mind, whether it's stock or fixed income or anything else. Don't just buy something because somebody wrote an article about it or somebody told you at the water cooler. It needs to be something that matches your own goals. So it's important to know what you're going to be using the money for."
-- Barbara O'Neill, Ph.D., CFP, financial management specialist at Rutgers University in New Brunswick, N.J.