A bank is a financial depository institution that keeps consumers and business accounts for savings or commercial purposes and engages in the business of lending, investing, and borrowing money. Retail banking refers to banking in which banks place transactions directly with consumers, rather than corporations or other banks. Retail bank services offered include: savings and checking accounts, mortgages, personal loans, debit cards, credit cards, and related transactions. In fewer words, a bank is a financial institution where one can place and borrow money.
There are several types of banking institutions in the United States. The three main types of financial institutions are banks, thrifts and credit unions. Banks, thrifts and credit unions have different histories and traditions and were established to serve different market functions. Where you choose to place your funds should have very little to do with the name of the type of financial institution we are labeling as a bank. Deregulation that swept through the industry starting in the 1980’s has made al three of these entities very similar in their product offerings, insurance protection and the services provided. There are some differences that may ultimately lead to regional benefits but as a rule the term bank has morphed into a very generic label.
For the sake of simplicity, we use the word “bank” to refer to all of the various types of FDIC insured banking institutions and credit unions that are federally insured by the National Credit Union Administration.
More often than not, all three of these financial institutions offer basic banking services such as; checking accounts, savings accounts, time deposits (certificates of deposit) and consumer loans with some of the larger institutions offering a wider array of services such as; credit cards, mortgages, and business loans. When comparing basic bank savings and deposit features, the mid sized to large financial institutions all offer the same menu of products regardless of the structure of the company. The one slight variation to this theme is the credit union. Credit unions are organized to serve a common customer and therefore do not generally have the ability to service customers with a large network of branches in a wide geographic area.
The variety of structures and names of these financial institutions is the result of different ownership composition, different mandates on the nature of their businesses and different regulatory oversight. Since the deregulation that has swept through the finance industry in the past 20 years, the term bank has been widely used to describe all three types of financial institutions. These financial institutions have now changed there initial authorized activities to such a degree that they all engage in similar, traditional banking activities. For the sake of simplicity, the term banks will be used to describe any of the following financial depository institutions.
Commercial Banks
Commercial banks were originally set up accepts deposits from the public and lends money to businesses and consumers. The term commercial bank is frequently used to refer to a bank or a division of a bank primarily dealing with deposits and loans from corporations or large businesses. The opposing type of bank, using this definition, was the retail bank that catered primarily to individuals. Commercial banking activities are altogether distinctly different than those of investment banking. Investment banking includes underwriting, acting as an intermediary between an issuer of securities and the investing public, facilitating mergers and other corporate reorganizations, and also acting as a broker for institutional clients.
Commercial banks are still the largest source of loans to small businesses. They also make consumer loans, including mortgages, and offer credit cards, deposit products and checking accounts for everyone. Now, most commercial banks offer accounts to everyone. Banks vary in size from mega banks with hundreds of branches nationwide to small community banks that specialize in serving the needs of the local clientele.
Thrifts
Thrifts is a term used to describe either savings and loans, savings banks or credit unions. Savings and loans are a form of thrift that can be either federally or state chartered and were originally established primarily to taking deposits from consumers and make residential mortgage loans. Although the activities of federal thrifts were once confined primarily to taking deposits from consumers and making residential mortgage loans, like most present day depository institutions, federal thrifts are now authorized to offer a wide range of financial products and services and have expanded to include virtually all traditional banking activities.
Mutual Savings Bank
Mutual savings banks are state chartered savings bank owned by its depositors, most often these forms of banks were established in the New England states.
The Office of Thrift Supervision is the primary regulator of all federal and many state-chartered thrift institutions, which include savings banks and savings and loan associations.
Credit Unions
Credit unions are the most unique form of financial institution that we generically call a bank. A federal credit union is a nonprofit, cooperative financial institution owned and run by its members. You become a member of the union because your deposit is considered partial ownership in the credit union. The deposits are regarded as purchases of shares, and all earnings of the credit union are paid out as dividends to members. To maintain their preferential tax status, credit union membership requires a common bond among the members, such as belonging to the same organization or living in the same geographical area. According to the Federal Credit Union Act, anyone can apply to join a credit union if he or she shares a common bond of employer, educational institution, branch of the military or government, church or community. Over the years, the growth of the credit union movement has resulted in nearly everyone being eligible for membership through some connection. Credit unions accept deposits from their members and use them to make short-term loans. Credit unions generally emphasize consumer deposits and consumer loan services. Increasingly they are becoming full-service financial providers with product portfolios that can compete with banks.
The downside of credit unions is access. Credit unions usually have fewer branch offices. Consumers will need to meet membership requirements to take advantage of credit unions’ services regardless of the location. In recent years, there has been a push by many credit unions broadening the scope of their membership. But though credit unions must restrict their membership to receive preferential tax treatment, 1998 legislation generally broadened credit unions ability to expand their membership base, though in 2006 the legislation began to be interpreted more restrictively.
The vast majority of credit unions in the United States are federally chartered or state chartered credit unions that are federally insured. The National Credit Union Administration is the federal agency that charters and supervises federal credit unions and insures deposits in federal credit unions and state credit unions that are federally insured.
With exception of credit unions, which are organized, as not for profit organizations, banks are similar to most other businesses. Banks operate by borrowing funds usually by accepting consumer or commercial deposits or by borrowing in the money markets. Banks borrow from individuals, businesses, financial institutions, as well as government entities. They then use those deposits and borrowed funds to make loans or to purchase securities. Banks make these loans to businesses, other financial institutions, and individuals. The vast majority of banking income comes from the difference on the interest they charge on loans and the interest they pay on depositors’ accounts. Banks also charge fees for services like checking, account access and maintenance as well as the loans made have their own set of fees that go along with them. Another source of income for banks is investments and securities. Interest rates provide the price signals for borrowers, lenders, and banks.
When choosing which financial institution serves you best, it is has become less of a concern as to whether it is retail bank, thrift or credit union. The choice of where your banking should be based is a more a measure of the services and products offered and how those features serve your needs. Even though there is still a differentiation between banks and thrifts, they offer many of the same services. Commercial banks can offer car loans, thrift institutions can make commercial loans, and credit unions offer mortgages. Protections through regulation and insurance have become more uniform as deregulation covered almost all facets of the banking industry.
The banking industry in the U.S. is a highly regulated industry with very detailed and focused regulators. The United States employs a dual system of bank regulation. The Federal Reserve is one of several banking regulatory agencies that operate on the federal level. At the state level, state chartered banks are regulated by their appropriate state banking regulator. State chartered banks can be supervised and regulated at both the state and federal levels. At the federal level, state-chartered banks are regulated by either the FDIC or, if they choose to be members of the Federal Reserve System, by the Federal Reserve. All banks with FDIC insured deposits have the FDIC as a regulator; however, for examinations, the Federal Reserve is the primary federal regulator for Federal reseve member state banks. The Office of the Comptroller of the Currency, or OCC, is the primary federal regulator for national banks. The Office of Thrift Supervision, or OTS, is the primary federal regulator for thrifts. State non-member banks are examined by the state agencies as well as the FDIC.
Depending on a banking organization’s charter-type and organizational structure, it may be subject to numerous federal and state banking regulators. The overlap in tasks among federal regulators and between federal and state regulators creates a confusing system that can be hard to follow. Each regulatory agency has their own set of rules and regulations to which banks and thrifts must adhere. The system seems to function well and has served both the industry and the industry’s customers well. Though there have been regulatory difficulties, the U.S. banking system is one of the safest, sound and open financial systems in the world.
The plethora of regulatory bodies starts with the primary federal regulators in the U.S. banking system which may be the Federal Deposit Insurance Corporation, the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision. Within the Federal Reserve Board there are 12 districts centered around 12 regional Federal Reserve Banks, each of which carries out the Federal Reserve Board’s bank regulatory responsibilities in its respective district.
The OTS is the federal bank regulator and supervisor of a dynamic and diverse industry of savings associations and their subsidiaries across the nation. The OTS also oversees domestic and international activities of the holding companies and affiliates that own these thrift institutions. The OTS is an office within the Department of the Treasury.
In 1989, Congress passed a law that dramatically restructured the banking business, moved deposit insurance for savings associations to the Federal Deposit Insurance Corporation and established the OTS to supervise, charter and regulate the thrift industry.
The OCC, the Office of the Comptroller of the Currency, is the primary regulator of national banks. A national bank is a financial institution chartered, regulated and supervised by the OCC. National banks have “National” or “N.A.” in their name. National banks represent about 23 percent of all insured commercial banks in the United States, holding 68 percent of the total assets of the banking system. The Office of the Comptroller of the Currency is a bureau of the United States Department of the Treasury. The OCC charters, regulates, and supervises about 1,700 national banks and about 50 federal branches of foreign banks in the U.S. (as of March 31, 2008) and their operating subsidiaries to ensure a safe, sound and competitive national banking system that supports the citizens, communities and economy of the United States. The OCC also supervises federally licensed branches and agencies of foreign banks.
State banks are chartered, regulated and supervised by their state’s banking division. State chartered banks regulation and supervision by the appropriate state regulatory agency of the state in which they were chartered applies in addition to federal regulation. State regulation of state chartered banks by the Federal Deposit Insurance Corp., is the federal regulator of state chartered banks that don’t belong to the Federal Reserve System. A state bank that is not a member of the Federal Reserve System would be regulated by both the state department that handles and regulations and the FDIC. A state bank that is a member of the Federal Reserve System would be jointly regulated by the state regulator and the Federal Reserve.
For members of the Federal Reserve System who are not national banks, and for offices, branches, and agencies of foreign banks located in the United States (who are not federal branches and agencies of foreign banks), the provisions are enforced by the Board of Governors of the Federal Reserve.
Credit Unions in the United States are subject to certain similar bank-like regulations and are supervised by the National Credit Union Administration. A federal credit union is a nonprofit, cooperative financial institution owned and run by its members and is not supervised or regulated by The Federal Reserve. The National Credit Union Administration regulates federally chartered credit unions, while state-chartered credit unions are regulated at the state level. The National Credit Union Administration (NCUA) is a federal agency that charters and supervises federal credit unions and insures savings in federal and most state-chartered credit unions across the country through the National Credit Union Share Insurance Fund (NCUSIF), a federal fund backed by the full faith and credit of the United States government.
The FDIC insures most all US banks and savings and loans for $100,000.00 per customer and $250,000.00 on retirement accounts. The FDIC insurance will cover all standard bank products such as:
Checking accounts
• NOW accounts
• Savings accounts
• Certificates of deposit
• Money market deposit accounts
FDIC insurance does not cover all bank products offered by an FDIC insured institution. Some products banks offered that are not covered by FDIC insurance will include:
Mutual funds and stocks
• Bonds, including Treasury bonds and savings bonds
• Insurance products including annuities, life, home, auto and related products
• Losses in a safety deposit box
• Errors made on accounts
• Fraud
Consumer Protection
The U.S has one of the most highly regulated banking environments in the world. Oddly, many of the regulations are not necessarily safety and soundness related. Most U.S. bank regulations are focused on rules and thegovernance of disclosures, privacy issues, fraud prevention, anti-money laundering, anti-usury lending, and promoting lending to lower-income segments. The Federal Reserve Board issues regulations that have varying levels of impact across the banking sysytem.
Some of the Federal Reserve Board regulations apply to the entire banking industry, whereas others apply only to its member banks, that is, state banks that have chosen to join the Federal Reserve System and national banks, which by law must be members of the System. The Federal Reserve makes consumer protection rules, including rules that implement the Truth in Lending, Home Mortgage Disclosure, and, Equal Credit Opportunity Acts, that all lenders, including credit unions, must follow. The Federal Reserve Board also issues regulations to carry out major federal laws governing consumer credit protection, such as the Fair credit Reporting, Equal Credit Opportunity, Truth in Lending, and Right to Financial Privacy. Many of these consumer protection regulations apply to various lenders outside the banking industry as well as to banks.
Right to Financial Privacy Act
This act establishes procedures for the release of financial records of consumers to government authorities. This act provides customers of financial institutions the right to expect that their financial activities will have a reasonable amount of privacy from federal government scrutiny. The act establishes specific procedures and exceptions concerning the release of customer financial records to the federal government.
Regulation E – Electronic Fund Transfers
Regulation E provides consumer protection, liabilities, and responsibilities of parties in electronic fund transfers (EFT) and protects consumers using EFT systems, such as ATMs and debit cards.
Regulation E establishes the rules for solicitation and issuance of EFT cards; governs consumers’ liability for unauthorized electronic fund transfers (resulting, for example, from lost or stolen cards); requires institutions to disclose certain terms and conditions of EFT services; provides for documentation of electronic transfers; sets up resolution procedures for errors; and covers notice of crediting and stoppage of pre-authorized payments from a customer’s account.
Stored-value cards or smart cards and home banking by personal computer is also subject to Regulation E because the act governs electronic fund transfers.
Fair Credit Reporting Act
The Fair Credit Reporting Act regulates the collection, sharing, and use of customer credit information. This act defines a credit reporting agency and implements procedures for maintaining fair and objective use of consumer credit information. The act allows consumers to obtain a copy of their credit report records from credit bureaus that hold information on them, provides for consumers to dispute negative information held, and sets time limits after which negative information is suppressed. The act establishes procedures for correcting mistakes on a consumer’s credit report and requires that a consumer’s record only be provided for legitimate business purposes. It also requires that the record be kept confidential. It requires that consumers be informed when negative information is added to their credit records, when adverse action is taken based on a credit report and if a consumer is denied credit, a free credit report may be requested within 30 days of denial.
Regulation D – Reserve Requirements
Regulation D imposes uniform reserve requirements on all depository institutions with transaction accounts or non-personal time deposits. The reserve requirements are based on various deposit account classifications and are important to consumers because they define transaction, savings and time deposit account categories. The regulation defines the deposit types and requires reports of deposits to the Federal Reserve.
Regulation BB – Community Reinvestment
Regulation BB implements the Community Reinvestment Act (CRA) and is designed to encourage banks to help meet the credit needs of their communities. Regulation BB requires each bank office to make available for public inspection a statement of the types of credit the bank is prepared to extend within the communities served by that office and provide a map of its communities. Each bank must maintain a file of public comments relating to its CRA statement. The Federal Reserve, in examining a state member bank, must assess its record in meeting the credit needs of the entire community, particularly low- and moderate-income neighborhoods, and must take into account the bank’s record in considering certain bank applications. A provision in the act requires public disclosure of a bank’s CRA rating and CRA performance evaluations.
Regulation B – Equal Credit Opportunity Act
The Equal Credit Opportunity Act states that creditors which regularly extend credit to customers, which include banks, retailers, finance companies, and bankcard companies, should evaluate candidates on credit worthiness alone, rather than other factors such as race, color, religion, national origin or sex. Regulation B prohibits creditors from discriminating against credit applicants, establishes guidelines for gathering and evaluating credit information, and requires written notification when credit is denied. Discrimination on marital status, welfare recipience, and age is generally prohibited with exceptions, as is discrimination based on a consumer’s good faith exercise of their credit protection rights. The regulation establishes a special residential mortgage credit monitoring system for regulatory agencies by requiring that lenders ask for and note the race, national origin, sex, marital status, and age of residential mortgage applicants. The regulation covers all credit transactions (unlike other regulations that may cover only consumer credit), with some modifications applicable to certain classes of transactions. The regulation also requires creditors to give applicants a written notification of rejection of an application, a statement of the applicant’s rights under the Equal Credit Opportunity Act, and a statement either of the reasons for the rejection or of the applicant’s right to request the reasons.
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Regulation DD – Truth in Savings Act
Regulation DD requires depository institutions to disclose the terms of deposit accounts to consumers and applies to all consumer deposit accounts except those offered by credit unions, which are governed by rules of the National Credit Union Administration. The purpose of the Truth in Savings Act is to enable consumers to make informed decisions about accounts at depository institutions. This part requires depository institutions to provide disclosures so that consumers can make meaningful comparisons among depository institutions. Specific information that must included in bank and savings instutition disclosures must include; written information about important terms of an account including the annual percentage yield, any fees and other information on any periodic statement sent to consumers, use certain methods to determine the balance on which interest is calculated and comply with special requirements when advertising deposit accounts.
Regulation CC Expedited Funds Availability Act
Regulation CC implements the Expedited Funds Availability Act (EFA) and governs the availability of funds and the collection and return of checks. This regulation establishes what are referred to as the availability schedules under which depository institutions must make funds deposited into transaction accounts available for withdrawal. The Expedited Funds Availability Act requires all banks, savings and loan associations, savings banks, and credit unions to make funds deposited into checking, share draft and NOW accounts available according to specified time schedules. The regulation also provides that depository institutions must disclose their funds availability policies to their customers. The law does not require an institution to holdup the customer’s use of deposited funds but instead limits how long any waiting period may last. In addition, Regulation CC establishes rules designed to speed the collection and return of checks and imposes a responsibility on banks to return unpaid checks expeditiously. The provisions of Regulation CC govern all checks, not just those collected through the Federal Reserve System.
Truth in Lending Act
Regulation Z requires disclosure of the finance charge and the annual percentage rate and certain other costs and terms of credit so that a consumer can compare the prices of credit from different sources. The Truth in Lending Act establishes uniform methods of computing the cost of credit, disclosure of credit terms, and procedures for resolving errors on certain credit accounts. It also limits liability on lost or stolen credit cards. It also gives consumers the right to cancel certain transactions involving their principal residence. A key provision of the regulation requires lenders to provide borrowers with good faith estimations of disclosure information before consummation of certain residential mortgage transactions. Other provisions governing lender requirements include; the requirement that lenders respond to consumer complaints of billing errors on certain credit accounts within a specific period, lenders identify credit transactions on periodic statements of open-end credit accounts, specific disclosure of credit terms to consumers interested in adjustable rate mortgages (ARMS) and home equity lines of credit are provided, abide by special requirements when advertising credit, provide certain rights regarding credit cards.
Home Equity Loan Consumer Protection Act
The Home Equity Loan Consumer Protection Act requires lenders to disclose payment terms, rates, APRs, miscellaneous charges and other features for home equity lines of credit with the applications and before the first transaction under the home equity plan. If the disclosed terms change, the consumer can refuse to open the plan and is entitled to a refund of fees paid in connection with the application. The Act also limits the circumstances under which creditors may terminate or change the terms of a home equity plan after it is opened.
Fair Debt Collection Practices Act
The Fair Debt Collection Practices Act is designed to eliminate abusive, deceptive and unfair debt collection practices. It applies to third party debt collectors or those who use a name other than their own in collecting consumer debts. Very few commercial banks, savings banks, savings and loan associations, or credit unions are covered by this Act, since they usually collect only their own debts. Complaints concerning debt collection practices should generally be filed with the Federal Trade Commission. This act defines which financial institutions are subject to the act and prohibits abusive debt collection practices. It applies to third-party debt collectors or to those who use a name other than their own in collecting debts.
Fair Credit and Charge Card Disclosure Act
The Fair Credit and Charge Card Disclosure Act requires new disclosures on credit and charge cards, whether issued by financial institutions, retail stores or private companies. Information such as APRs, annual fees and grace periods must be provided in tabular form along with applications and preapproved solicitations for cards. The regulations also require card issuers that impose an annual fee to provide disclosures before annual renewal. Card issuers that offer credit insurance must inform customers of any increase in rate or substantial decrease in coverage should the issuer decide to change insurance providers.
Bank Consumer Complaint Filings
The Federal Reserve can help individual consumers by answering questions about banking practices, and investigating complaints about specific banks under its supervisory jurisdiction. Complaints about financial institutions that are not supervised by the Federal Reserve System are referred to the appropriate federal agency.
As a federal regulatory agency, the Federal Reserve System investigates consumer complaints received against State chartered banks that are members of the System. If you think a bank has been unfair or deceptive in its dealings with you, or has violated a law or regulation, as a consumer you have the right to file a complaint.
If the consumer has a complaint against a financial institution, the first step is to contact an officer of the institution and attempt to resolve the complaint directly. Financial institutions value their customers and most will be helpful. If the consumer is unable to resolve the complaint directly, the financial institution’s regulatory agency may be contacted for assistance.
The agency will usually acknowledge receipt of a complaint letter within a few days. If the letter is referred to another agency, the consumer will be advised of this fact. When the appropriate agency investigates the complaint the financial institution may be given a copy of the complaint letter.
The complaint should be submitted in writing and should include the following:
Although the Federal Reserve investigates all complaints involving the banks it regulates, it does not have the authority to resolve all types of problems. For example, it is unable to resolve contractual disputes, undocumented factual disputes between a customer and a bank, or disagreements about bank policies and procedures. These matters are usually determined by bank policy and are not addressed by federal law or regulation. In many instances, however, by filing a complaint a bank may voluntarily work with you to resolve your situation. If, however, the matter is not resolved, the Federal Reserve will advise you whether a violation of law has occurred or whether you should consider legal counsel to resolve your complaint.
Bank and Credit Union Regulatory Contacts
Board of Governors of the Federal Reserve System
Division of Consumer and Community Affairs
20th and C Streets, N.W., Stop 801
Washington, DC 20551
(202) 452-3693
Federal Deposit Insurance Corporation
Compliance and Consumer Affairs
550 17th Street, N.W.
Washington, DC 20429
(202) 942-3100 or 1 (800) 934-3342
Comptroller of the Currency
Office of the Ombudsman
Customer Assistance Unit
1301 McKinney Street
Suite 3710
Houston, TX 77010
1 (800) 613-6743
Office of Thrift Supervision
Consumer Programs
1700 G Street, N.W.
Washington, DC 20552
(202) 906-6237 or 1 (800) 842-6929
National Credit Union Administration
Office of Public and Congressional Affairs
1775 Duke Street
Alexandria, VA 22314-3428
(703) 518-6330
Federal Trade Commission
Consumer Response Center
6th and Pennsylvania, N.W.
Washington, DC 20580
877-FTC-HELP – toll free (877-382-4357)
When comparing the different types of banking products available, whether they be checking accounts, money market accounts, CDs or even money market funds or Treasury bills, is it always prudent to determine your financial goals as a first step to successful investing and finding the account with which you are most comfortable.
You may have immediate goals or long-term goals or simply evaluating which accounts serve your bill paying and record keeping needs.
Generally, your goals will dictate how much risk should be in the investment, the level of liquidity and the time you have to invest. Once an investor has established their investment goals and needs, a realistic investment plan that includes checking accounts, CDs and money market accounts can be designed to meet these goals. A realistic expectation about investment returns and about market performance is an important part of any cash allocation decisions.
Long term goals should be separated from short term savings needs. Typically, a shorter time frame necessitates conservative investments, while a longer period allows you to handle more risk. Remember, investments that increase in value in a short period can just as quickly decrease in value. But if you’ve considered the risk/reward tradeoff, you know that investment volatility is a characteristic of a successful long-term plan. Establish your goals and create an investment plan now the sooner you begin saving money with your bank and investing in the right type of accounts, the longer your money has to work for you and the greater the value of compounding accrued interest will become.
High yielding money market deposit accounts, low cost checking accounts, high rate CDs and money market accounts can be appropriate investments for a variety of investment goals. Throughout our changing financial needs, most individual investors will com across the need for savings that can include making a down payment on a home, paying for a wedding, retirement or creating an emergency fund.
In preparation for retirement or managing your funds while in retirement, individuals should use a combination of sources to fund retirement, which may include Social Security benefits, employer-sponsored retirement plans-like 401(k) plans, Individual Retirement Accounts (IRAs) and personal savings. To maintain diversification and liquidity, personal savings should include a measurable level of funds in bank accounts, CDs and money market funds.
Since investment securities don’t always rise in value, and when they fall, the downturns can sometimes be lengthy, every investor should keep a keen eye on the returns provided by CDs and money market funds. A well-conceived, diversified personal investment plan can help you weather these downturns, and give you a measure of comfort when market volatility occurs.
Emergency reserves are assets you may need unexpectedly on short notice. Many investors use bank accounts and bank products like high yielding CDs for their emergency reserves and short term investing goals.
Consumers use bank products for a variety of needs. One of the most fundamental of these needs is a place to store short-term savings. Emergency reserves are assets you may need unexpectedly on short notice. Bank products are generally considered to be on the very low end of the risk spectrum of investing are one of the most appropriate investments types for short-term targets. In turbulent times, the returns and extra safety of bank checking, savings, money market deposit accounts and certificates of deposit can be invaluable resource in overall financial planning. In addition, everyone should have a short-term savings balance that is reasonably liquid and safe. Your savings should reflect your time horizon, financial situation, and personal feelings about risk.
Liquidity for investors is usually defined as the ability to readily access invested money. More specifically, it is a measure of the cash equivalency of an investment. Safety for investors is generally defined as the ability to preserve principal. FDIC insured accounts would are the ultra conservative end of the principal preservation spectrum.
Short-term savings are accounts usually established to cover three types of events. The fist event is for unseen or sudden financial needs. This category could include events such as sudden medical needs, unexpected home expenses or an abrupt loss of income. The second event is for a place to temporarily hold savings for short-term expected large expenses. In this category there could be events such as the planning for a large home improvement expenditure, a significant durable good purchase or even college tuition. These expenses can be planned for but the funds that re being set aside to cover the costs should be placed in accounts that are safe and liquid. The last category is to be prepared for our lifestyles and needs change over time. The marketplace changes as our economy fluctuates. Interest rates and rates of return will tend to move more dramatically as the world economies mature and the established risks will most surely need to be reevaluated. Whenever you make a major lifestyle alteration, it’s time to reassess your overall financial condition. Some broad examples of lifestyle adjustments that should trigger a review of an individual’s asset in liquid and safe investments include: having a child, retirement, career changes, starting your own business, new marriage or divorce.
Short-term needs should be evaluated more than just once as our lifestyles and needs change over time. Most of these events are likely to affect your ability to invest, your time horizon, and your overall financial picture, both short term and long-term. It’s never easy to find the time to review your investment plan when you’re in the midst of any of these life changes, but it’s worth making the effort. You don’t want to enter a new phase of your life with a plan that was designed for different circumstances. By staying on course with your asset allocations, you will help ensure that your overall portfolio continues to work effectively toward achieving your investment goals.
In addition to goals, identifying your time horizon is important because it influences how you invest your assets. Typically, a shorter time frame necessitates conservative investments, while a longer period allows you to handle more risk.
How much to set aside for short term savings needs is frequently debated by financial planners and is influenced by many factors specific to the individuals needs. One key starting point is to establish between three months to nine months of living expenses in a short-term savings account or accounts. After determining those needs, the next consideration should be your overall willingness to accept risk balanced with current risk and return of your financial investments. More conservative individuals will want funds stashed in relatively risk free accounts where those with a higher tolerance for risk would want these funds kept to the necessary minimum level. Age can play a significant role in this decision. More mature investors are more likely to be risk adverse and more heavily tilted towards capital preservation. Along with age, the amount of funds in short term safe investments should reflect the upcoming needs for large cash outlays. Younger consumers will generally have a greater need for down payment savings, college tuition costs or home improvement needs.
Saving for short-term goals is ultimately a way to save money, whether it is used to pay for unseen events or as store for financial. Evaluate the wide variety of investment options available to determine which best match your needs. For short-term savings needs, whether it is designed to cover sudden unexpected expenditures, preplanned large financial disbursements, or a safe heaven for turbulent times, bank products are certainly one of the resources available to fill these needs. With the plethora of bank products and money market instruments available, there is almost always a product or various products to meet your requirements. Consider the products rate or return, liquidity, safety and potential tax implications.
Most banks offer a great variety of different accounts, but they generally fall within one of these four types: savings accounts, checking accounts, money market deposit accounts, and certificates of deposit. Most banks offer all of these types of accounts although they may fall under different names. With the variety of account types and specialized names that some banks will give their accounts it can be difficult to select what account best suits your needs. It will certainly behoove the prudent shopper to choose the account type they want first, so they can focus on that type of account as they shop around to various banks reviewing the rates, features and fees between competing financial institutions.
Banks offer these financial products and more for their depositors that will have many features that benefit both the bank and the depositor. When you put money into a bank account, you are allowing the bank to use the money you have deposited. Altruism is the primary mission of the U.S. banking system. A deposit account is a specific type of current account at a banking institution that allows money to be deposited and withdrawn by the account holder. There are different types of bank deposit accounts, though, and they pay different rates of interest and have varying restrictions and fees. An account that allows you to write checks, for example, provides you with a definable benefit, so it pays a lower rate than a savings account, which does not offer this benefit. If you agree to leave your funds in a savings account for a specified time without withdrawal, you are providing the bank with some benefits to potential increase their profit. The bank knows for certain that it will keep your deposit, and it knows it can use the funds longer than if you had deposited them in, say, a checking account. In return, the bank will pay you a higher rate than on an account from which you can withdraw your funds at any time.
Within the four categories of bank products, the banking industry and regulators classify the accounts in a different method. These classifications usually pertain to the reserve requirements that the financial institution have to meet and the funds availability rules established by the Federal Reserve. These accounts are usually grouped as follows:
Transaction accounts are:
Checking accounts
Negotiable orders of withdrawal accounts or NOW accounts
Credit Union Share draft accounts
Automatic transfer service (ATS) accounts.
Savings accounts are:
Share accounts at credit unions
Passbook savings accounts
Statement savings accounts
Money market deposit accounts.
Time deposits are:
Certificates of deposits (CDs)
Certain categories of club accounts
Share certificates at credit unions.
The checking account is one of the most common accounts used by the banking consumer. There are many different types of checking accounts – all with various benefits and rules attached. Some are perfect for paying bills and expenses. Some pay interest, and others do not. Some will provide customers with unlimited number of checks while others charge for each check the account holder writes. Some checking accounts require a minimum balance be maintained each month.
Banks will offer differ in the names they give some of these accounts, but the product has changed little over the years. With a checking account you use checks to withdraw your money from the account. You may use checks to pay your bills, purchase products and services (at businesses that accept personal checks), send money to friends and family, and many other common uses. You can also use checks to transfer money into accounts at other financial institutions. You have quick, convenient, and, if needed, frequent-access to your money. Typically, you can make deposits into the checking account as often as you choose. Many institutions will enable you to withdraw or deposit funds at an automated teller machine (ATM) or to pay for purchases at stores with your ATM card. Checking accounts are often divided further into basic checking accounts and interest bearing checking accounts.
Basic Checking Accounts
A checking account is a demand deposit account subject to withdrawal of funds by check. A demand deposit is the most common type of transactional account. Money is available to the account holder without any advance notice or on demand by writing a check, making a withdrawal from an automated teller machine, or transferring funds from one account to another. Checking account features vary widely from institution to institution. Many accounts include fees for blank checks and deposit ticket orders, for the number of checks written, and for returned checks and overdrafts. Other common fees are a general service charge or maintenance fee and a fee if the minimum balance falls below a certain level.
Interest Bearing Checking Accounts
Most types of banks and financial institutions also offer interest bearing checking accounts. These accounts are demand deposit accounts similar to basic checking with the exception that they pay interest to account holders based on the amount of funds in the account. Checking accounts that pay interest were often referred to as negotiable order of withdrawal (NOW) accounts. That term is still used, however most banks use more creative names to label these classes of checking accounts.
The fees found in basic checking accounts may also be found on interest bearing checking accounts as well. In addition, minimum balance fees are more common and there may be a minimum amount needed to open the account. The interest rate on these accounts often depends on how large the balance in the account is and fluctuates greatly from bank to bank. Comparison shopping on demand deposit accounts can be especially important since checking accounts that pay interest charge higher fees than do regular checking accounts, so you could end up paying more in fees than you earn in interest.
Savings Accounts
With savings accounts you can make withdrawals, but you do not have the flexibility of using checks to do so. Funds held in a savings account may not be as convenient as from a demand account. These types of accounts are offered by commercial banks,
savings and loan associations, credit unions, and mutual savings banks they often pay slightly more interest than the checking accounts but can not be used directly as money by writing checks to access the funds.
These accounts are not classified as transaction accounts. However they can generally be easily accesed by ATM or bank branch, instead of writing a check or using a debit card. The transference capabaility in these acounts is easy enough that savings accounts are still considered very liquid.
Some savings accounts require funds to be kept on deposit for a minimum length of time, but most permit unlimited access to funds. U.S bank regulations limit the withdrawals, payments, and transfers that a savings account may perform. Banks comply with these regulations differently; some will immediately prevent the transfer from happening, while others will allow the transfer to occur but will notify the account holder upon violation of the regulation. True savings accounts do not offer check writing privileges, although many institutions will call their higher interest demand accounts or money market accounts savings accounts.
All savings accounts will offer an itemized list of available financial transactions. Some savings accounts charge a fee if your balance falls below a specified minimum.
Passbook savings or bank statement savings are intended to provide an incentive for you to save money. You can make deposits and withdrawals, and though you usually can’t write checks, they usually pay an interest rate that’s higher than a checking account, but lower than a money market account or CD.
Savings accounts will have either a passbook, in which transactions are logged in a small booklet that you keep, or produce a monthly or quarterly statement detailing the transactions. With a passbook savings account you receive a record book in which your deposits and withdrawals are entered to keep track of transactions on your account; this record book must be presented when you make deposits and withdrawals. With a statement savings account, the institution regularly mails you a statement that shows your withdrawals and deposits for the account.
Money Market Deposit Accounts
Money market accounts are a type of savings account offered by financial institutions that behave just like regular savings accounts with some added features. Money market deposit accounts are interest-bearing account that allows you write a limited amount of checks each month. Since the account is not considered a transaction account, it is subject to the regulations on savings accounts. The accounts were created to give banks a product to offer higher interest rates to the depositor and still provide the feature of check writing.
These accounts don’t always, but usually pay higher interest but also have higher minimum balance requirements. As they do with checking accounts, most institutions impose fees on money market accounts.
Since money market accounts such as these are bank accounts, the money in a money market account is insured by the Federal Deposit Insurance Corporation (FDIC). With credit unions, the money in a money market account is insured by the National Credit Union Administration (NCUA), also a federal agency.
These accounts are used by banks to maximize their ability obtain higher rates of return by investing or lending longer term The rates they offer tend to be slightly higher than those on interest-bearing checking accounts, but they usually require a higher minimum balance to start earning interest. These accounts provide only limited check writing privileges (three transfers by check, and six total transfers, per month), and often impose a service fee if your balance falls below a certain level.
Certificates of Deposit (CDs)
Certificates of deposits, or CDs are a form of time deposits. The name, time deposit, aptly sums up the meaning of this type of bank deposit. The key component that differentiates the certificate of deposit from other accounts is that the depositor agrees to leave their funds in the account for a specified period of time. The terms or time periods can range anywhere from one month to ten years. Once the account holder has chosen the term they want, the bank will generally require that you keep your money in the account until that term ends, referred to as the maturity. Because the account holder agrees to leave their funds in the bank for a predetermined period of time, the account holder is compensated with a higher interest rate.
Certificates of deposit provide convenience and ease of investing. In today’s market when consumer are buying a certificate of deposit, the account holder will not usually get an actual certificate but there will be a book entry and it will show up on monthly bank statements. A certificate of deposit is very easy to invest making the certificate of deposit very convenient investment vehicle. Most of the time, you can just walk into a bank and buy a certificate of deposit with a banker. You can also buy a certificate of deposit online without having to open an investment account.
CDs not only provide the guarantee of principal when held in an FDIC insured financial institution, but they are also very easy to manage. When you invest in a CD you know when the term or the maturity is and therefore know exactly when all of your funds become available and you also know what the rate of return you will receive is during that time period. These features along with their suitability in the need to maintain a diversified portfolio have led to the enormous amount of money held in these products.
If something comes up and you need access to your cash, it is possible that you can get your money out of the CD before the maturity date. The maturity is the date by which the issuer promises to repay the investments face value and any remaining accrued interest. However, if you withdraw your funds prior to the maturity date there will most likely be a cost involved. You may have to pay early withdrawal penalty. Penalties vary among banks, and they can often be substantial. The penalty could be greater than the amount of interest earned, so you could lose some of your principal deposit.
CDs come with a variety of different terms and conditions. CDs can be purchased for terms of almost any length or term. When the CD reaches the end of its term, matures, the funds can usually be rollover into another CD at the prevailing market rate of interest. When the CD reaches maturity or the term expires, you can cash out the principal and interest, or roll over the CD for another term at the current market rates being offered by the financial institution you have the CD with. Most banks will continually renew CDs for you after maturity; however, the rate may be different if CD interest rates have changed since you bought the first CD.
CDs have different options when it comes to paying interest on the account. Many CDs will deposit the interest into one of your accounts monthly or quarterly. Other CDs will add the interest back into the CD or pay the interest at the end of the CD term. The issuing bank by and large determines the method of interest payments.
Even though certificates of deposit will generally have higher interest rates than most other bank products, they are still considered one of the safest and conservative investment vehicles out there since the rate of return is relatively low on the accounts and the Federal government up to a limit insures them. The investor of a certificate of deposit can invest small amounts in a certificate of deposit. This availability of small investments in a certificate of deposit differentiates investing in a certificate of deposit from investing in other investment vehicles. A money market security, for example, usually requires a minimum amount of investment for any decent money market rate of return. The ability to invest both small amounts and large sums of money into a certificate of deposit investment makes investing in a certificate of deposit popular among elderly people or parents investing for their children or grandchildren.
The interest rates for CD’s can vary depending on many factors, including; the bank, the credit market, the amount of money you are investing and the length of the term. When looking at the overall picture of CD rates the biggest factors influencing the market for CDs is the length of time until the CD matures, and the current interest rate environment.
How CD Rates are Established
There are two main factors that affect bank CD rates:
The longer you’ll have your money tied up, the higher your rate will be. Check our rates and you’ll almost always find that banks with the best CD rates go up as the length of time increases. CD’s with longer maturities, time periods, pay higher rates than those with shorter maturities. Generally, the rate paid on the CD with regards to their maturity is the same for all interest bearing investments, the rates increases as the time to maturity or duration increases. This is because the longer you commit to leaving your money, the more flexibility the bank has with your money. They are willing to pay you a better rate because they can use the money for a wider variety of purposes.
The current interest rates environment is also an important factor in determining what the prevailing rates on certificates of deposit may be. That is because bank CD rates are set according to other competitive rates in the market. Interest rates that you earn on all of these deposits are influenced by yields on Treasury billsor short-term corporate IOUs. Yields on these instruments are, in turn, influenced by the Federal Reserve’s decision to cut or raise the fed funds rateas part of its monetary policy. The economy in general combined with forces emanating from the Federal Reserve influence what competitive interest rates are, and that shapes what the market for CD rates are.
Other factors can influence bank CD rates. For example, you may find that a bank is trying to win some short-term business by offering slightly higher rates. They know that there are people out there shopping with banks for the best CD rates, and they hope that once they get a customer in the door the customer will stay.
Risks with CDs
Not all CDs are created equal, so investors need to ask questions and understand exactly what they’re buying. Investors need to learn its maturity date, where the money will be deposited, and the penalties for early withdrawal, any costs associated with selling before maturity and whether the interest rate is fixed or variable.
Because of the inherent safety in certificate of deposits, yields on CDs tend to be lower than other higher risk investments. Like all fixed income paying contracts or investments, CD rates are subject to fluctuations in interest rates. If interest rates rise, the rates on outstanding CDs will generally rise as well. However, since changes in interest rates will have the most effect on longer maturities, short-term CDs are less susceptible to interest rate movements. Interest rate fluctuations are a greater concern for rolling over future investments. The interest rate on a fixed rate CD is fixed until maturity, its rate will not fluctuate. If a CD is sold prior to maturity they are subject to a penalty that limits the liquidity of the investment. The secondary market may also be limited. Some planners will mention the possibility of credit risk, since CDs are a debt instrument, there is credit risk associated with their purchase. The insurance offered by the FDIC mitigates almost all of this risk.
The risk of interest movements can be broken into two different risks, opportunity cost and inflation risk the opportunity cost of a long term fixed interest investment is the inability to now se that money for potential higher paying returns.
Let’s look at your $50,000 one-year CD again. It’s paying you 4%. Assume that prevailing rates have jumped to 6% by the time the maturity date hits. You’ll continue to get your $2,000 per year, even though newly issued CDs earn more. But what if you’d like to get your money out and reinvest at the new, higher rates? With most CDs you will stuck with a early withdrawal penalty.
What are you giving up for the convenience of having a checking account? Consider a bank certificate of deposit that requires an average monthly balance of $1,500 for a checking account. If you can earn 2% a year in interest in a savings account, maintaining this checking account means giving up $30 in potential interest income. If you keep larger balances, you’re sacrificing additional interest income.
Inflation Risk is the risk that a portion of an investment’s return may be eliminated by inflation. All fixed rate investments have the potential for inflation risk. Think of inflation as an invisible tax that erodes the purchasing power of any investment. For example, $10,000 in a certificate of deposit account earns 4 percent interest, but inflation is 3 percent per year. Although this money will earn $400 in interest after one year, inflation cuts the actual worth of this $400 down to $100. In addition, the initial $10,000 will also erode by 3 percent to $9,700. To maintain an investment’s purchasing power, its total return must keep pace with the inflation rate.
While these instruments play an important role in your overall financial plan, especially with the dual qualities of safety and relative liquidity, you need to be aware that they may not protect your assets against all risks.
CD Laddering
CD laddering is method of protecting a segment of your overall investments from the ups and downs in the interest rate market. With a CD ladder bank customers can reduce the risks of a long-term commitment and still take advantage of long-term rates by alternating, or laddering, the CD maturities, so that some are always coming due in the near future but never all at one time. If a CD account holder doesn’t need the cash when one of the CDs matures, they can rotate these maturing certificates back into new long or short term maturities, depending on the CD rates available at the time they mature.
During most normal markets, the interest rate paid by banks on almost type of interest bearing security is greater the longer the term of the deposit. Five year CDs generally pay more than one year CDs. When you pick these longer-term certificates of deposit, you get a better interest rate on your money, but you also possibly lose out if the current interest rates in the market were to increase measurably.
With the CD ladder technique, the account holder distributes their investments over a period of several years with the goal of having several different maturities instead of just large CD that matures all at once. This way part of the money matures annually, and when that money comes back in, he or she can reinvest it over a long period of time. This way the depositor reaps the benefits of the longest term interest rates with an overall higher rate of return while still having enough liquidity to re-invest the money, or withdraw it in short term intervals.
A CD ladder is started by buying several CDs at one or more banks at one time but with different maturity dates, for example, buy a one year term CD, a two year term CD, a three year term CD, a four year, and five year CDs. Every year one of the CDs will mature at different times and can cashed in ort rolled over into a new CD with a similar term at the prevailing best CD rate.
A CD ladder can be as long or as short as you like, but for this example let’s use a five-year ladder with five different maturities or rungs in the ladder. If you have $10,000 to invest, you’d invest $2,500 in each rung. You could put $2,500 in a one-year CD, $2,500 in a two-year CD and continue up to $2,500 in a five-year CD.
After a year, the one-year CD occupying the first rung matures and each of the other CDs has one less year until maturity. In other words, the two-year CD now matures in one-year; the three-year is two years from maturity, etc.
The money from the one-year CD that has just matured is rolled over into the now vacant five-year rung. Every year you’re replacing the rung that’s farthest out — in this case the five-year rung.
You can choose a shorter or longer term when you begin the ladder, but the key is to use the same term for each one once you start rolling them over at maturity. At the end of five years you’ll have five CDs with one maturing every year after that, so you’ll never have all of your money tied up long-term or at lower than market interest rates.
For example, if you have $2,000 to put in CDs, consider putting $500 each in a three-month, six-month, one-year, and two-year certificate. When the three-month CD matures, roll it over into a six-month certificate. Do the same when the first six-month CD matures, and continue rolling over so that you’ll always have a certificate within three months of maturity.
By always replacing the longest maturity, which is the top rung on the ladder, you’re always reaping the benefit of earning the highest interest rates. If interest rates happen to be in a slump one year, you’re only reinvesting a portion of your investment when yields are low. And you don’t have to try to guess when rates are at their highest because you’re constantly reinvesting.
CD laddering is a smart way to protect yourself against fluctuations in interest rates while giving you the security of knowing that you will be able to access at least some of your money within a relatively short time frame. More often than not, the responsibility of maintaining this ladder falls on the investor, rather than the bank. This can be advantageous for banks with competing interest rates, but it can often be a time consuming proposition.
The Truth in Savings Act requires that when a customer opens a certificate of deposit account they must be provided with any information about ladder rates penalty fees for early withdrawal of a portion or all of the funds.
Callable CDs
Most CD accounts offer a fixed interest rate, which means that you will not lose any money if prevailing market interest rates fall. The bank that issues the CD has the exact opposite problem. When rates fall the bank would benefit by paying off or returning the funds on the higher paying CDs and replace them with the lower current interest rate.
A certificate of deposit product that will in fact protect the bank in a falling interest rate environment is the callable CD. The callable CD gives the issuing bank the right to stop paying the agreed rate of interest and call the CD during a set period of time. A callable CD allows the financial institution to redeem your CD after a designated period of time. This right is given to the bank issuing the CD, but they do not give you that same right. If interest rates fall, the issuing bank might call the CD. In that case, you would receive the full amount of your original deposit plus any unpaid accrued interest up to that time. Unlike the bank, you can never call the CD with the bank and get your principal back.
Just like a regular CD, a callable CD is a certificate of deposit that will pay a fixed interest rate over its lifetime. The only feature that differentiates a callable CD from a traditional CD is that the bank owns the call option on the CD and can redeem the CD from you for the full amount before it matures. The incentive for the account holder who has to take the risk that the bank may call the CD is a slightly higher interest rate on the callable CD. Callable CDs will, as a rule, pay more interest than a regular CD. With a callable CD you can earn a higher rate of return but be cautious, if rates drop and the bank wishes to exercise their rate to call your CD, you’ll have to shop for a new one with a lower rate of return. With a regular or traditional CD you incur the risk of a rising interest rates market and can be stuck in a long-term CD paying below market interest rates.
With callable CDs compare the APY of those CDs with comparable term traditional CDs. Be mindful of the call date on the CD. This is the date that the issuer can call your certificate of deposit. Let’s say, for example, that the call date is six months. This means that six months after you buy the CD, the bank can decide whether it wants to take back your CD and return your money with interest. Don’t confuse maturity date with the call date on a callable certificate of deposit. If a CD is described as a one year callable CD, this does not necessarily mature in one year. The one-year refers to the period of time you have before the bank can call or redeem the CD, the actual amount of time until maturity of the CD maybe longer. In fact, it’s not uncommon to find callable CDs with maturities that run for several years, perhaps five to ten year terms or longer. The call date generally does not start for a period of time, protecting the CD holder from allowing the bank to call the CD quickly.
A Callable CD is more likely to be redeemed by the bank when rates decline. If interest rates fall, the bank might be able to borrow money for less than it’s paying you. This means the bank will likely call back the CD and force you to find a new vehicle to invest your money in.
If prevailing interest rates increase, it is not likely that a bank would call a CD. The bank would have no incentive to call a CD that the bank was paying a lower rate on that it would have to pay at the current market conditions. It would simply cost the bank more to borrow these funds elsewhere.
Bump Up CDs
One of the shortcomings of long term CD investments is that while you own the CD interest rates may climb higher and you could be locked into one with a lower rate. To satisfy the need for depositor’s anxiety over changing interest rates when their funds are locked into a term CD, some banks have offered a type of CD called a bump up CD. A bump up CD allows the account holder the ability to bump up the rate on their CD to a higher rate if the current interest rate market during that time has increased. The rate on these CDs is generally slightly lower than a comparable term CD at the start to compensate the bank for the option it provides you. The period of time in which the account holder can exercise the right to increase or bump up to the newer higher rate is also restricted to a predetermined window of time. Most banks offering these CDs also limit the option to increase to a higher rate to just one rate increase during the term of the CD. The potential trade off is when interest rates don’t increase and you will have lost the interest income that is the difference between a regular CD and the bump CDs initial lower rate.
Jumbo CDs
Jumbo CDs are similar to standard certificates of deposit but the initial deposit to open a jumbo CD is much larger. The typical minimum investment for a jumbo is $100,000.00. Like the traditional certificate of deposit, the jumbo CD requires that the account holder leave the principal amount in the account for a predetermined period of time. The term of these CDs vary depending on the bank but are similar in length to traditional CDS as well. Early withdrawal penalties will apply to these CDs, the amount of the penalty will be dependent on the issuing bank. Since the jumbo CD amount is above the initial insured amount of an individual account at an FDIC insure bank, the risk on these accounts are slightly higher. As a rule, the interest paid on the account will also be higher.
Liquid CDs
The inability to access your funds without penalty is a tradeoff when investing for the higher yields that a certificate of deposit offers. To try to satisfy the needs of consumers reluctant to use a CD do to the early penalty withdrawals of CD investments, some banks offer liquid CDs or flexible CDs. Liquid CDs give the account holder the right to withdraw money from the CD without incurring penalties. The money has to stay in the account for designated number of days before the funds can be withdrawn, this is a requirement not only set by the bank but one that is established by the Federal Reserve. The time and number of withdrawals are also limited over the term of the CD. Flexible or liquid CDs will usually have a lower rate than comparable regular CDs that do not provide an early withdrawal option.
If you want your savings to grow at competitive CD rates but you also want to be able to draw on your funds without having to pay traditional CD early withdrawal penalties, a liquid or flexible CD is one option. With these CDs it is important to understand the terms and conditions of the withdrawals as well as the rate of interest paid. Often, the amount of funds that the certificate of deposit holder can withdraw is very limited and a minimum balance must be maintained.
Zero Coupon CDs
Zero coupon CDs or no interest CDs do not have periodic interest payments. These CDs are sold for slightly less than the principal value of the CD at maturity. The technical definition states that the zero coupon CD is originally sold at a discount to its face value. When the CD term ends, the full face value is paid out and the difference between the discounted purchase price and the face value represents the interest on the CD.
They are designed to be sold at a discount and the interest is then the entire amount earned on the investment over the term of the CD. As an example, if you purchased a $1000.00 face value that matures in one year for $890.00, the additional $110.00 that you receive at maturity is the interest paid. The length of term on these CDs is usually for several years. Although you do not receive the interest during the term of the CD, the IRS requires that the interest that is paid at maturity be calculated over the whole term and taxes maybe due based on that interest income as if you had received it.
Variable Rate CDs
Variable rate CDs, also known as floating rate CDs, are CDs that have interest rates that can change. Variable rate CDs pays an interest rate that can adjust to the movement in market interest rates based on an index. The rate paid on these CDs is usually tied to a common interest rate index such as U.S Treasury rates. If rates go up during the term of the CD, the CDs rates can adjust upward, if rates drop, the rate paid on the CD will also drop. These CDs will have conditions that limit the amount of times the CD can adjust during its term as well as a time period during which the adjustment can take place.
These CDs will usually have a slightly lower start rate than a fixed rate CD with comparable terms. The benefit of variable rate CDs is the potential to earn a higher rate should the index the CD is based on rise during its term. Since the start rate is modestly lower, these CDs may be beneficial for those depositors that wish to preserve principal and still have opportunity to earn higher yields without the added risk of non bank or FDIC insured interest bearing assets.
Some factors to consider before buying variable rate or floating rate CDs include:
The index on which the rate paid on the CD is based.
The difference between the rate paid now and the interest rate paid on a fixed rate CD of a similar term.
The time period during which the interest rate can adjust.
The number of times the interest rate may adjust.
The minimum interest rate paid.
The maximum interest rate that can be achieved.
The spread between the index the CD’s rate is based on and the rate that is paid on the CD.
Brokered CDs
Most investors and bank customers traditionally purchase CDs through local banks, however, many brokerage firms now offer high yielding CDs as well. These brokerage firms are sometimes referred to as “deposit brokers”. The brokers can sometimes negotiate higher rates of interest on CDs by pledging to bring a certain quantity of deposits to a financial institution. The deposit broker can then offer these high rate CDs as “brokered CDs” to their own customers.
Since brokered CDs first became a funding alternative in 1982, hundreds of financial institutions have issued CDs for sale to investors through some of America’s most prestigious brokerage firms. Before you consider purchasing a CD from your bank or brokerage firm, make sure you fully understand all of its terms. Carefully read the disclosure statements, including any fine print. And don’t be dazzled by high yields. Ask questions – and demand answers – before you invest.
Brokered CDs are CDs issued by banks that are made available to customers through a deposit broker. Nearly all CDs that are sold through brokers are through deposit brokers are securities brokers that are registered with the Securities and Exchange Commission. Some deposit brokers that market and sell CDs are subject to regulation by different regulatory bodies or may not be subject to regulation at all. Though, brokered CDs are made available or purchased through a broker, brokered CDs are direct obligations of the bank that issued the CD, not the broker.
Brokered CDs generally have the features of CDs available directly from banks and are eligible for the same deposit insurance as CDs purchased directly from banks.
Generally, the CD is sold to you without a fee because the broker receives its compensation from the bank. You have a right to know the amount of the fee paid to the broker by the bank. In addition, because federal deposit insurance is limited to a total aggregate amount of $100,000 for each depositor in each bank or thrift institution, it is very important that you know which bank or thrift issued your CD. In other words, find out where the deposit broker plans to deposit your money. Also be sure to ask what record-keeping procedures the deposit broker has in place to assure your CD will have federal deposit insurance.
Brokers may provide additional services to you that would normally be provided by the bank. The broker will hold your CD as your custodian and keep a record of your holdings. The broker will include your CD holdings in the periodic account statements you receive concerning the assets you have with the broker. Tax information concerning the amount of interest you should include in y our income for tax purposes will also be provided by the broker.
Unlike banks, securities brokers are required to provide you with an estimated market value of your CD on your periodic account statement. This is an estimate of the amount you might receive if you were able to sell your CD prior to its maturity. You may not be able to sell your CD for the amount listed on the statement. Also, the amount on the statement does not affect your deposit insurance, which is based on the outstanding principal amount of your CD, not the estimated market value.
When you hold your CD through a broker you have certain rights, including the right to dismiss the broker as your agent and move the CD to an account at another broker or establish the CD directly with the bank. Once you establish the CD directly with the bank your broker has no further obligation with respect to the CD. Within a few days of your CD purchase, a securities broker will provide you with a trade confirmation that sets forth the terms of your CD. In addition, the broker will send you a CD disclosure document describing your rights with respect to the CD, the availability of deposit insurance coverage and other important considerations. The disclosure document will usually be sent with the trade confirmation, but is also available upon request. You should review these documents carefully and ask your broker if you do not understand the terms and conditions of your CD or if the terms and conditions are different than you were told when you placed your order.
Though not obligated to do so, some securities brokers may be willing to purchase, or arrange for the purchase of, your CD prior to maturity. The broker may refer to this activity as a secondary market. This is not early withdrawal. Some brokered CDs are issued in the name of the “custodian” or deposit brokers. In some cases, the deposit broker may advertise that the CD does not have a prepayment penalty for early withdrawal. In those cases, the deposit broker will instead try to resell the CD for you if you want to redeem it before maturity.
The price you receive for selling your CD with a broker will reflect a number of factors, including then-prevailing interest rates, the time remaining until the CD matures, the features of the CD and compensation to the broker for arranging the sale of the CD. Depending on market conditions, you may receive more or less than you paid for your CD. If interest rates have fallen since you purchased your CD and demand is high, you may be able to sell the CD for a profit. But if interest rates have risen, there may be less demand for your lower-yielding CD. That means you may have to sell the CD at a discount and lose some of your original deposit. The broker is free to discontinue offering you this service at any time.
Taxable Interest and CDs
Finding the best CD rates may also involve the evaluation of tax rates and tax consequences of the interest earned. You may be able to defer taxes on your CD interest by holding it in an IRA or other retirement account. You may owe taxes when your funds are distributed from those accounts.
You may be required to pay taxes annually on zero-coupon CDs and some conditional interest CDs if you hold the CD outside a retirement account even though these CDs do not pay interest annually. The tax consequence on the original issue discount may be significant even though no interest is paid directly.
Questions about the tax consequences of any particular CD or ownership type should be answered by a tax adviser.
IRA CDs
An IRA is an Individual Retirement Account that is a personal savings plan which provides either a tax-deferred or tax-free way of saving for retirement. There are many different types of accounts of IRAs, depending on the financial goals and situations of each individual, though traditional and Roth IRAs are the most common choices for individuals saving money for retirement purposes.
IRAs are a mainstay for a variety of retirement strategies. By adding a fixed rate certificate of deposit to a retirement plan, an account holder can increase savings with insured and predictable interest earnings. Certificates of deposit are a conservative retirement investment favored by many retirees when the stock market is doing poorly or as a tool for diversification. On fixed rate IRA certificates of deposits the account holder knows what the return is going to be when they are purchased and they are federally insured up to $250,000 when they are bought for individual retirement accounts. In 2006, the FDIC and NCUA raised the insurance limit for IRAs to $250,000 per institution.
An IRA CD can be an invaluable way to generate steady, secure returns and add stability to the stock and bond portions of a retirement portfolio. As long as the amount in the account is within the FDIC insurance thresholds, the account is protected and liquidity can be maintained or managed by selecting different terms of maturity for the IRA. Most IRAs held in bank account are for long term CDs. However, many banks offer a wide variety of term choices for IRA CDs. It may be prudent to actively managing the optimal return by choosing the best CD rate even if it requires evaluating the rate spreads between competing products and varying terms. Choose the best CD rate with appropriate term from 3 months to 5 years, with a broad selection of competitive, tax-advantaged APYs, maximize your return by staying abreast of the market.
An IRA certificate not only allows for the possibility to invest a certain amount of money over a specified period of time, but a IRA CD’s can have considerably higher interest rates in comparison to the traditional saving accounts. As with most CDs. the longer you keep your money in a CD, the higher the interest rate will be. For most CDs, the interest earned within a CD is taxable each year, even if the money is not withdrawn from the CD. However, for CDs purchased within IRA accounts, any applicable taxes come into play upon withdrawal of the funds, rather than as they accumulate.
When a CD is purchased with IRA funds, the federal IRA rules apply. For instance, if you purchase a CD with funds inside of a traditional IRA, the money cannot be withdrawn from the IRA until age 59-1/2 without penalties, or under special circumstances. So, once the CD matures, the money must be reinvested in another CD or other investment vehicle (stocks, mutual funds, annuities, etc.), as long as it stays in the IRA.
Direct IRA CDs have the advantage of complete control of the funds. The CD is opened up under the owner’s title and social security number. Some banks even waive early withdrawal penalties on IRA CDs, often banks do not charge an annual custodial fee either. And with the ability to manage the term of the CDs, if the best CD rate is no longer the best at maturity you can move your funds to another IRA CD with a higher rate.
Some investors in IRA CDs prefer shorter time periods when it comes to the investments, such as 6-month certificates of deposit, while others enjoy the sometimes-higher rates of 3- or 5-year CDs. Flexibility, surety and safety are clearly the overwhelming lure of IRA funds invested in CDs.