Non-Traditional CDs

In today’s market and economy a certificate of deposit with a guaranteed, fixed interest rate, looks like a good safe haven.  Like many other products in today’s market, banks are adding more and more new features to what most people see as a solid, safe and relatively unexciting investment.

Banks are using these new features to attract new customers and many of the features are designed to compensate for lowered interest rates – new packaging on a standard product. Some of these new features have clear trade-offs so it is important for any investor to understand what they are getting into.  The most common variations of the standard bank CD are, Bump Up CDs, Step Up or Step Down CDs, Variable Rate CDs, and Liquid CDs.

First, let’s review the basics of a traditional certificate of deposit.  The CD account holder receives a fixed interest rate over a specific period of time.  When that term ends, the CD owner can withdraw their money or roll it into another CD.  Withdrawing before maturity can result in a significant early withdrawal penalty.  Consequently it is not in your best interest to withdraw the money before the maturity date unless you really need to or have another investment with a significantly higher rate of return.

Next we can review the various types of non-traditional CDs.  In exchange for the benefits of the special features, the length of the term that is available or interest rate will vary.  Take the time to do your homework before you invest.

Bump Up CDs.  A Bump Up CD allows the account holder the option to increase the interest rate once during the term of the CD.  Upon request, the bank will “bump up” the interest rate on the certificate of deposit to a higher rate being offered by the issuing bank on that CD (or a comparable term CD).  The rate change does not change the original maturity date of the CD.

If you are ready to put money in a certificate deposit but worry that interest rates will go up, the Bump Up CD can be a good idea.  If rates rise, you’re guaranteed the option of bumping up to a higher rate for the remainder of your term.  If rates fall, you’ll still be locked into the same great yield for the term of your CD.

Liquid CDs.  This type of CD is generally a fixed rate certificate of deposit, which allows you to withdraw a portion of the original deposit during the term without paying a penalty.  There will be some limits on when you can take the money out, the amount that can be withdrawn and how many separate withdrawals you can make from the CD.  If you are ready to invest in a CD but think you may need some of the funds before the end of the term, this may be the right vehicle for you.

Callable CDs.  The bank has the right to “call” or buy back this type of certificate of deposit after a specific time period, returning the original CD principal investment plus accrued interest.  These CDs generally pay a higher interest rate than a non-callable CD.  On the call date, the bank can determine if it is better for them (cheaper) to replace the investment or leave it outstanding.  The risk to the investor is that the bank will exercise the call when interest rates fall significantly below the rate initially offered, capping your rate of return.  These typically pay a quarter point or so higher rate since you are assuming some risk.

Brokered CDs.  This is not a type of CD but refers to where it is purchased.  These are offered by brokerages (Schwab, Fidelity or Vanguard for example) and often these have call options.  These CDs are more liquid than bank CDs because they can be traded like bonds on the secondary market.  With this flexibility comes risk.  If interest rates have fallen since you purchased the CD you may be able to sell it at a profit. Of course, of rates have risen and you need to sell it, you may have sell at a loss.

Step Up CDs or Step Down CDs.  These can also be called a flex CD.  Certificates of deposit with a step up or down feature have a fixed interest rate for a period of time, usually one year and then the interest rate automatically rises up to a predetermined rate or is lowered to a predetermined rate.  Step up CDs will have a higher rate in subsequent years while a step down CD will have a lower rate in subsequent years.

Bump-Ups (where you are allowed to increase the rate once within the term) are often confused with Step-Up CDs, which automatically step up to higher rates at specific intervals.  The new interest rate is generally determined by the interest rate being offered on CDs with the same term as the original term of this type of account.  The maturity date of the CD does not change.

Variable Rate CDs.  Unlike traditional CD’s that pay a fixed rate of interest, a variable rate CD or index based CD is tied to the outcome of a market index.  The interest you earn at maturity is based on the percentage gain (or loss) from the Initial Index to the final Index value.

These certificates of deposit can be tied to a bond or stock index or a reference rate like the Treasury bills, Prime Rate or the Consumer Price Index.  The rate of return on these CDs will depend on changes to this index or reference rate.  Your principal investment in these market-based CDs is generally guaranteed against downside risk.  Many investors looking at certificates of deposit may not be looking for market volatility, however, variable rate CDs can be a good investment option.  It is important to fully understand all the terms of these CDs.

Add On CDs.  These are fixed are or variable rate CDs to which you can make additional deposits.  There can be restrictions, such as a minimum deposit that can be made to the account.  The entire balance of the CD, including any additional deposit amounts, earns the same interest rate that was established when the account was open.

Zero Coupon CDs.  These certificates of deposit are issued at a substantial discount from the face amount of the CD.  Typically the maturity terms are much longer, 15 to 20 years, which results in the discounted price.  Zero coupon CD’s do not pay interest until the maturity date.  It is important to take some caution before investing in a Zero Coupon CD, however.  You may not receive any income from this CD until the maturity date, but you are taxed on it each year unless this is held in a tax-deferred account.

Tags: add on CDs, banks, brokered CDs, bump up CDs, callable CDs, CDs, interest rates, liquid CDs, step up CDs, variable rate CDs

This entry was posted on Tuesday, February 10th, 2009 at 3:33 pm and is filed under Money Rates. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.