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Bank Certificates Of Deposit (CDs)
by Peter Passell

The federally insured band CD is the workhorse of American savings, a safe, predictable addition to the nest eggs of tens of millions of Americans. What you see is what you get, as long as the CD is guaranteed by the Federal Deposit Insurance Corporation. But there is enormous variety in CDs, and investors need to be alert to both the opportunities for earning more interest and the potential downsides in choosing a CD with unusual terms.

Some specifics. CDs are "term deposits"--you specify how long you are willing to lock up the money, and the bank specifies the interest rate it will offer. The terms of most CDs run from six months to five years, while the interest rate is usually fixed when the CD is issued. But the FDIC gives banks wide latitude in setting the length of their commitment (some run as short as one month, some last as long as fifteen years), in determining how the interest rate is set (some ratchet up with time or change along with rates on other securities). In exacting a penalty for early withdrawal ( the FDIC insists on a minimum of seven days' worth of interest, but some banks collect as much as six months' interest). Hey, the sky's the limit: banks can (and have0 linked the returns on federally insured CDs to indexes ranging from oil prices to the dollar's exchange rate with various foreign currencies.

The vast majority of CDs permit you to cash them before they mature (after paying a penalty), but the contract doesn't give the bank the right to terminate the arrangement before the date of maturity. That's good for you, since it leaves you the option of liquidating a CD early and buying a new one if the interest rates rise. But, of course, this arrangement is bad for the bank.

By contrast, some bank CDs sold through securities brokers do give the issuer the right to "call" the CD after a year or two. Such CDs are not necessarily bad investments--the issuing banks usually offer higher interest rates in exchange for your acceptance of the call provision. But you need to understand that your money will likely be handed back just when the opportunities for reinvesting the proceeds in another high-interest CD are lowest.

Most CDs come in $1,000 slices. But banks are free to set lower (or much higher) minimums. Some banks are happy to pay extra interest for "jumbo" CDs--that is, CDs over $100,000. But take care here: FDIC insurance is limited to $250,000 per owner per bank, and that limit will ratchet back to $100,000 at the end of 2009 unless Congress extends the new, enriched maximum. It makes a lot of sense, then, to spread the money among many banks if your savings top the insurance max.

Not, too, that the bank issuing the CD has wide discretion in how frequently it makes interest payments, and whether it "compounds" the interest--that is, pays interest on the interest accumulating within the account. This matters for two reasons. First, the CD paying the highest rate may not actually pay the highest return. Happily, the FDIC requires banks to disclose the one number that does make direct comparison possible--the APY, which is short for "annual percentage yield."

Second, the FDIC insurance limits apply to the total funds an individual has in the bank. Interest that has accumulated, but has not been paid out, counts against the limit. Generally this won't matter. But some CDs work like U.S. savings bonds, paying the interest only when the CD matures or is prematurely cashed. Here, the difference between the amount initially invested and the value of the mature CD can be quite large. For example, $225,000 accumulating at 5 percent interest for five years would lead to a payoff at maturity of a bit more than $287,000--$37,000 more than the current insured maximum.

Interest on CDs, incidentally, is subject to income tax in the year the interest is earned--not the year it is actually paid. So, if you have the sort of CD that accumulates interest within the deposit, expect the bank to report the interest earnings to Uncle Sam even if you have yet to see a penny of it.

More on CDs and other tips on investing in today's volatile economy can be found in the book Where To Put Your Money NOW by Peter Passell.

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