The ABCs of how CDs work

Investors searching for relatively low-risk investments that can easily be converted into cash often turn to certificates of deposit (CDs).

A CD is a special type of deposit account with a bank or thrift institution that typically offers a higher rate of interest than a regular savings account. Unlike other investments, CDs feature federal deposit insurance up to $100,000.

How CDs Work

When you purchase a CD, you invest a fixed sum of money for fixed period of time — six months, one year or five years. In exchange, the issuing bank pays you interest, typically at regular intervals.

When you cash in or redeem your CD, you receive the money originally invested plus any accrued interest. But if you redeem your CD before it matures, you may have to pay an early withdrawal penalty or forfeit a portion of the interest you earned.

Although most investors have traditionally purchased CDs through local banks, many brokerage firms and independent salespeople now offer CDs. These individuals and entities — known as "deposit brokers" — can sometimes negotiate a higher rate of interest for a CD by promising to bring a certain amount of deposits to the institution. The deposit broker can then offer these "brokered CDs" to their customers.

At one time, most CDs paid a fixed interest rate until they reached maturity. But, like many other products in today's markets, CDs have become more complicated. Investors may choose among variable-rate CDs, long-term CDs, and CDs with other special features.

Some long-term, high-yield CDs have "call" features, meaning that the issuing bank may choose to terminate — or call — the CD after only one year or some other fixed period of time. Only the issuing bank may call a CD, not the investor. For example, a bank might decide to call its high-yield CDs if interest rates fall. But if you've invested in a long-term CD and interest rates subsequently rise, you'll be locked in at the lower rate.

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.

Next Week

Tips that can help you assess what CD features make sense for you.

Zall, Bureaucratus columnist and a retired federal employee, is a freelance writer based in Silver Spring, Md. He specializes in taxes, investing, business and government workplace issues. He is a certified internal auditor and a registered investment adviser. He can be reached at milt.zall@verizon.net.