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RETIREMENT INCOME TIPS:BANKS AND CREDIT UNIONS |
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RETIREMENT INCOME TIPS:BANKS AND CREDIT UNIONS |
WHAT ARE CERTIFICATES OF DEPOSITS and the DIFFERENT TYPES?A CD is a bank savings instrument with a specified maturity. Maturities can be for any term length, but most range from three months to five years. Interest may be credited daily, weekly, monthly, quarterly or yearly, and compounds and accrues until the CD is cashed in or matures. Over the last twenty years the average interest paid on certificates of deposit has ranged from around 1% to almost 18%, and these yields may swing violently between one period and the next. As an example, CD rates dropped 69% from the fall of 2000 to the fall of 2001. CD rate increases tend to be slower - a typical 1-year CD yielded 1% at the end of 2003 and didn't reach 4% until the end of 2006.
Certificate of deposit yields are usually higher than money market accounts and, based on our research, yields earned on 5-year CDs might well exceed average rates earned on Series EE Savings Bonds. Interest is fully taxable, even when money is compounding inside the CD. Over the past thirty years, taking into account the rate of inflation and assuming the effects of a top marginal income tax rate, real CD returns after taxes and inflation have been negative half of the time. The typical CD penalty for early withdrawal is usually six month’s interest, but could be one year's interest if the CD term is two years or longer; the penalty for maturities of less than a year is often only the loss of one month’s interest. Certificates of deposit are FDIC insured and subject to FDIC limits. You can buy CDs where the interest rate paid may increase or decrease over time based on a set schedule, or where the interest you earned is linked to the performance of an equity index, or even where it is denominated in a foreign currency. Your CD may be “callable” whereby the bank can pay you off prior to maturity at their whim (usually when new CD rates are lower than your current rate). However, “callable” is a one way street, a depositor cannot “call” the bank (if rates go up) and tell them to send you your money without penalty. You can redeem a traditional CD by going to the bank, surrendering the CD and paying the penalty, but some of these newer CDs cannot be cashed in before the end of the term. It is possible you may be able to sell the CD – like you would a stock – but as with a stock the price may be more or less than you originally paid. And you may not hear what you thought you heard. If someone told you about a “penalty free, five year non-callable CD” you might think you heard about a CD with a five year maturity having no penalties for early withdrawal. However, the reality could be a CD that does not mature for 10 years, but that the bank cannot take it away for at least 5 five years, and the reason there are no penalties for early withdrawal is because the CD cannot be withdrawn until the end of the term. MARKET-LINKED, INDEXED, STRUCTURED CERTIFICATES OF DEPOSIT
Although they use different names they all refer to a certificate of deposit where the interest earned is based on the movement of an external index, that could be the S&P 500 or foreign currencies or inflation or almost anything else. These CDs are typically FDIC insured and may even guarantee a minimum return or place a cap on the amount of interest you can own. The ones I have seen usually do not lock in the interest until the end of the 3-5 year term, so if the index was up for 4 years and then plunged in the last year you could wind up earning zero interest (this is different from almost all of the index annuities on the market because they usually credit any index-linked interest earned annually, but there are a few index annuities that do not lock in interest annually and wait until the end of the term). However, even in the worst case the CD still gives you your principal back at the end of the term.
BROKERED AND CALLABLE CERTIFICATES OF DEPOSIT
Another type of certificate of deposit is a “brokered” CD. These CDs may pay higher interest than the local bank and they are covered by FDIC insurance limits, but with some if you surrender before maturity you may get the “market value” of the CD, which could be more or less than you initially paid. In addition, some CDs are "callable" – meaning the bank can stop paying interest and send you back your money at their discretion – and this usually happens when current rates have dropped lower than what your callable CD is paying. Depending upon how they are offered a "brokered" CD could be viewed as a security and is not discussed on this site.
If it is a “brokered” CD you also need to know the bank behind it. The reason is if you are already maxed out on FDIC coverage at one bank, and the same bank issues the brokered CD, you might find part of your money would not be FDIC insured. And as long as we are talking about “brokered”, since CD brokers may not have a license or be state registered, check them out very carefully. The SEC has CD tips available on their web site at http://www.sec.gov/investor/pubs/certific.htm |
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