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January, 2007


The last word on certificates of deposit presumably should come from one's professional money manager, broker, banker, or financial consultant. Here I am simply seeking to provide a quick summary and will not delve at all into such interesting alternatives as equity-tied CDs, bump-up CDs, callable CDs, tax-free CDs, zero-coupon CDs, inflation-adjusted CDs, or other non-traditional types of certificates of deposit, most of which might not be appropriate for the majority of investors in any case.

Definition: A certificate of deposit (CD) is a promise from a bank or brokerage, to which funds have been deposited, to repay them to a particular individual, partnership, or business. It specifies the name of the depositor, the amount, a defined duration (usually months or years), and an established rate of interest. Normally, but not always, the rate is partly dependent on the funds being left on deposit for the specified period, so often there is a penalty for early withdrawal.

Since there are now a number of financial vehicles (such as federally insured money market accounts) that provide relatively safe income to an investor or saver, some of which are more liquid (easy to buy and sell or to deposit into and withdraw from) than CDs and many of which also pay higher yields (interest rates), there is not so much reason for tying up funds in a CD, even for only a few months, as there may have been in decades past, when not so many options existed, or when the convenience of simply dealing with one's local bank for setting aside funds and drawing interest, rather than a brokerage or mutual fund company, may have offset the benefits of shopping around for the best return. Today, both banks and brokerages usually offer quite an assortment of different ways to gain income on one's funds, some more traditionally bank-like and others more conventionally brokerage-like.

In addition, one can do one's shopping online where access to some of the best yields in either CDs or other financial instruments may be but a few clicks away.

However, banks probably sell some of their local customers on the efficacy of locking up their funds in CDs for awhile by telling them the certificates of deposit pay more than the average savings account or than some money market accounts. It is true that they can offer higher returns in this way, but frequently one could do better by simply investing through a mutual fund company instead of a bank. I have seen mutual fund money market accounts that paid a 50% higher or greater return than similar financial instruments provided by banks. In the past, at least, the bank would generally not disclose these higher yielding money market accounts when describing their own CDs' advantages over (their own) relatively low yielding money market accounts.

But supposing that, on whatever basis, maybe the promise of a higher rate under specified conditions, maybe the security of a relationship with a trusted individual or institution, one is inclined to invest in CDs, is satisfied with the annual interest rates they provide, and does not mind leaving the funds alone for the minimum period, what is a good way to invest in certificates of deposit? The most recommended approach I have come across is that of laddering one's CDs.

Laddering involves buying financial vehicles of different durations, for instance 1-, 3-, 5-, and 10-year CDs. The yields on the same type CD generally will increase as the duration goes up. So, on average a laddered CD portfolio will add a higher level of safe income to one's nest egg than short-term ones alone.

Then if the prevailing interest rates rise, it will not be long before some of the short-term laddered CDs mature, and so their funds can be reinvested at the then higher available yield levels. On the other hand, if rates fall, one's CD portfolio continues for quite awhile to provide the higher yields of the longer maturity holdings.

I have never owned a CD and so have no personal experience with their advantages. I have heard, though, that many folks with high incomes, and so plenty of funds to put regularly into savings, enjoy the convenience and reliability of a regular program of investing with CDs of varying maturities.

I look forward to the day when/if we have enough extra income that such an easy parking arrangement for some of it has more appeal!

(Many thanks to both Valerie and Evelyn for providing inspiration or information for this essay.)


Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)

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