Certificate of deposit

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A certificate of deposit (CD) is a debt instrument issued by a bank or a credit union. A CD earns its stated interest for the stated term and pays interest at a stated frequency (monthly, quarterly, or annually). CDs at credit unions are sometimes called money market certificates. Unlike a money market fund, there is no credit risk with a money market certificate as long as you stay within the deposit insurance guarantee.

Please see CDs vs bonds as well.

Role in a portfolio

  • General savings vehicle. If you know the date on which you need a large amount of cash (car, college tuition, vacation, etc), you might consider opening a CD such that it will mature just before the date.
  • A part of fixed income allocation in a retirement portfolio. A common method of holding CDs in a portfolio is laddering.

Risks

Credit risk

When purchased correctly, CDs do not have credit risk. Only bank accounts and treasury bonds share this enormously valuable feature of a government guarantee.

CDs from qualified banks are insured by Federal Deposit Insurance Corporation (FDIC). CDs from qualified credit unions are insured by National Credit Union Administration (NCUA). You can make sure the institution you are buying from is covered by FDIC or NCUA by checking their status:

CDs should never be purchased in an amount above $250,000, in order to stay within this guarantee. If interest is redeposited into the CD rather than a bank account, you should not purchase a CD with a face amount above $225,000.[1]

If you want to safely invest more than $250,000 at the same institution, you can do so using payable-on-death (POD) labeling. For example, a couple with two children can insure $2.5 M. (They would hold a joint CD with $500 K; an individual CD each; 3 CDs for her POD for each of him, child 1 and child 2; and 3 CDs for him POD each of her, child 1 and child 2). Details are at the Bankdeals blog and the FDIC. The FDIC Insurance Electronic Deposit Insurance Estimator (EDIE) can help make sure you do this right.

Banks fail regularly and so it is critical to take these rules seriously. Do not ever buy CDs greater than the insurance guarantee or at a non-guaranteed institution. In particular, there are a small number of credit unions that are not insured by the NCUA. Even if these credit unions offered slightly higher rates on their CDs (and they generally don't), it would not be worth forgoing the government guarantee. If you have large amounts of money to invest in CDs, you should investigate the private CDARS service, which automatically distributes your money (up to $50 M) across a large number of institutions.

Inflation risk

CDs are effectively nominal bonds. Therefore, they suffer from the same potential inflation risk. You are guaranteed to be paid back principle plus interest, but there is no guarantee that the future dollars will be worth as much as present dollars.

For that reason, the Bogleheads Investment Philosophy is to combine nominal bonds in your portfolio with inflation-protected bonds such as TIPS or I bonds.

Early withdrawal penalty

Figure 1. Form 1099-INT

If you need money in your CD before it matures, you may be subject to early withdrawal penalty. This penalty is deductible as an adjustment to income on a federal income tax return. The early withdrawal penalty will be shown in box 2 of the 1099-INT form (see Figure 1.) According to a survey conducted by Bankrate.com, early withdrawal penalties vary widely. The most common penalties are 3 months and 6 months interest.

Taxation

CDs are not tax efficient. If used as part of fixed income allocation in a long-term investment portfolio, CDs should be placed in a tax-deferred account. If held in a taxable account, interest from CDs is taxed as ordinary income for federal income tax. Unlike money market funds, there are no tax-exempt CDs. Taxation at the state level vary. Some states, including Massachusetts, may exempt interest from in-state banks.

Where to Buy?

When purchasing CDs, there is a trade-off between convenience and yield. The following is a list of options, in order of increasing yield and decreasing convenience.

Your local bank or credit union

When saving money for a specific future cash need, it can be simplest to purchase a CD with money from your checking account. These rates are always better than checking account interest, but often are not very good. Also, beware of "teaser" rates that automatically roll-over into much lower yielding CDs when they mature. You often have just 10 days or so to stop a roll-over, so be sure to mark your calendar.

Brokered CDs

Brokers sometimes can negotiate a higher interest rate on a bank-issued CD because they can bring a large amount of deposits to the bank. But, CDs sold by brokers can be complex and may carry more risks than traditional CDs sold directly by banks, especially in terms of your ability to lock in an attractive interest rate or get your money back early.[2][3]

Because federal deposit insurance is limited to a total aggregate amount of $250,000 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. Your deposit broker may plan to put your money in a bank or thrift where you already have CDs or other deposits. You risk not being fully insured if the brokered CD would push your total deposits over the $250,000 federal deposit insurance limit.[3]

Good account records by your deposit broker can ensure your CD will have federal deposit insurance and, in the event of a bank closing, you’ll be paid quickly. For example, unlike traditional bank CDs, brokered CDs are sometimes held by a group of unrelated investors. Instead of owning the entire CD, each investor owns a piece. Confirm with your broker how your CD is held, and be sure to ask for a copy of the exact title of the CD. If several investors own the CD, the deposit broker will probably not list each person's name in the title. But you should make sure that the account records reflect that the broker is merely acting as an agent for you and the other owners (for example, "XYZ Brokerage as Custodian for Customers"). This will ensure that your portion of the CD qualifies for full federal deposit insurance coverage.[3][4]

Vanguard Brokerage Services

Vanguard (as well as other brokerage firms) offers brokered CDs from hundreds of different banks. All CDs available through Vanguard Brokerage Service are FDIC or NCUA insured (though you must stay below the limits). They also have the advantage that interest payments (which are often made monthly) are deposited directly into the money market you have linked to your brokerage.

The downside is that the very best deals are not available as brokered CDs. So, you'll generally do better than your local bank but not as good as searching out the very best deals.

PenFed

If you want to get consistently good rates but not have to set up new accounts every year, the Pentagon Federal Credit Union has offered some of the consistently highest rates over time. Anybody can join by paying a one-time $20 fee to a non-profit organization National Military Family Association (NMFA), which is available as part of their enrollment process. Or, join for free if you are a volunteer for the American Red Cross.

PenFed also currently has a uniquely good deal for those over 59½ investing in their IRA, in that they allow early withdrawals. Bogleheads normally keep their IRAs at Vanguard, but if you're planning to invest substantial sums in CDs, moving your IRA or a portion of your IRA to PenFed may be worthwhile.

Yield Chasing

Different banks and credit unions around the country are constantly offering special deals to attract new customers. If you're willing to fill out the paperwork to move your money, you can get the highest yield CDs by moving your money to whatever bank is offering the best deal as your old CD matures. Many banks now offer online setup and ACH money transfers, although the paperwork to move an IRA is often more difficult.

The best source for finding bank deals is at DepositAccounts.com. There, you can see a list of all deals available for the length CD you want. Many deals are only for residents of certain states or cities, or people who have an affiliation with some employer or group.

For some people, yield chasing is a hobby, and they get a thrill knowing that they've found the very best deal. For others, constantly setting up new accounts can seem extremely tedious compared to the VBS or PenFed options.

See also

References

  1. The standard insurance amount currently is $250,000 per depositor. See Understanding Deposit Insurance
  2. When a Broker Offers a Bank CD: It Pays to Do Some Research, from the FDIC
  3. 3.0 3.1 3.2 High-Yield CDs – Protect Your Money by Checking the Fine Print, from the SEC. See Special Considerations for Brokered CDs section.
  4. Forum discussion: Brokered Deposits / CDs -- Proper Documentation

External links