CDs, for a Return Guarantee
The Certificates Are Safe, but They Can Also Tie Up Money

By Elizabeth Razzi
Special to The Washington Post
Sunday, September 16, 2007

Sometimes boring is beautiful.

With the stock market whipping investors along gut-wrenching swings of 200 points or more in a day, the steady-as-she-goes FDIC-insured certificate of deposit has lately become an attractive shelter.

For Lisa Bend, the time to act came when she kept seeing reports that the Federal Reserve may soon lower interest rates, which could cause CD rates to drop. Wanting to lock in a good rate, Bend, 43, recently put a portion of her retirement savings into nine- and 12-month CDs from Internet bank ING Direct. She got an annual percentage yield, or APY, of 5.25.

"I had it sitting there, and I didn't know what to do," said Bend, who lives near Philadelphia. "I was looking at the stock market going up and down and up and down the past month."

A safe investment, surely, in volatile times. But there is a price to be paid for a guaranteed return. If you tie up your money for six months to a year or two, you could miss out if stock prices suddenly take off again.

So CDs, while a stable refuge, work most effectively as one component of a portfolio. Over the long term, stocks provide the best opportunity for your assets to grow. Historically, the U.S. stock market has offered investors annual returns averaging a little more than 10 percent if dividends are re-invested.

"Most investors are best with a diversified mutual fund portfolio," says Joe Garrison, a certified financial planner with Strategic Wealth Management Group in Columbia. Such diversification would include stock funds, bond funds and money-market instruments in a mix tailored to match the risk an investor can comfortably bear. Generally, the more time the investor has until the cash is needed, the greater the share that can be devoted to stocks.

CDs can fill a niche for many investors, even those comfortable keeping most of their money in stocks. They are particularly attractive for people in or nearing retirement who cannot afford to risk losing principal or interest. They're also useful for younger investors who would like to park money that they will need in six, 12 or 18 months for a tuition payment, a car, vacation or the down payment on a home. Stiff early-withdrawal penalties, often equal to three to six months' interest, are a strong incentive to keep your hands off the money until the CD matures.

The investments are not paying bad returns, considering that most guarantee not only your principal but also the interest it is slated to earn. And if you're among those betting that the Fed will lower its benchmark short-term interest rate when it meets Tuesday, you might want to follow Bend's lead and lock in the higher CD rates sooner rather than later.

Early last week, annual percentage yields averaged between 3.53 percent for six-month CDs to 4 percent for those maturing in five years, according to Greg McBride, senior financial analyst for Bankrate.com, a Web publisher that tracks consumer interest rates available nationwide. Shopping can get you an above-average rate of up to 5.5 percent for the highest-paying CDs, he said.

"Typically, CD yields move in advance of Fed action; however, we haven't yet seen that move play out," McBride said. "If there's a screaming 'buy' signal for CDs, that's it."

A search for the best rates should include Internet-based banks as well as local banks and credit unions. Some banks offer Internet-only deals that carry a slightly higher yield than available through their branches, according to McBride.

For example, Countrywide Bank has an online-only offer ranging from 5.5 APY for a three-month CD to 5.65 APY for a 12-month. Longer-term CDs earn less: 4.6 APY. The minimum investment is $10,000 for a regular CD; $2,500 for one used in an individual retirement account, or IRA.

IndymacBank.com was quoting APYs ranging from 5 percent for three-month CDs to 5.7 percent for those that mature in five or six months. They have a $5,000 minimum investment for Internet accounts.

Rates on longer-term CDs, ranging from 18 to 60 months, were lower than those offered for shorter terms. ING Direct was quoting 5 percent, for maturities ranging from 18 months to 60 months, and IndymacBank offered 5.2 percent for maturities between 18 months and five years. "That's a reflection that interest rates are expected to decline," said McBride. "Banks don't want to be on the hook for an above-market yield for the long term."

The idea of locking in a guaranteed return of more than 5 percent for several years is pretty compelling for a consumer, even if a slightly higher rate could be earned in the short term.

Jim Kelly, chief operating officer for ING Direct, said that, to account for higher risks, markets usually place a higher price on long-term instruments. But that's not the situation today. "Markets are very nervous, and banks and other companies who need money are paying to get their hands on it," Kelly said.

When financial institutions are not anticipating a decline in interest rates, it's common for longer-term CDs to carry a higher interest rate than short-term commitments'. To take advantage of the longer-term rates, an investor can build a "ladder" of CDs in a way that ties up most of the money at higher, long-term rates, while keeping a portion of it available for re-investment each year.

For example, if you had $25,000 to invest in CDs, you might build a ladder with five rungs, with the rungs representing CDs of different duration. The top rung is a five-year commitment; the second rung is a four-commitment, and so on. You fund each with $5,000. One-fifth of your total investment would mature each year, allowing you to re-invest the money at the highest prevailing rate. This gives you the ability to lock in attractive rates for the long term without running the risk that all of your money would be tied up in the event that interest rates rise.

As with all investments, it's crucial that an investor pay attention to the fine print before investing. In particular, check to see if it is "callable," which entitles the bank to call off the deal before maturity if market rates decline. The bank would return your principal and the interest earned to date. Callable CDs should offer you a higher interest rate in return for your acceptance of that risk.

Check the details on how your funds will be handled when the CD reaches maturity. Many institutions automatically roll over your funds into a new CD of the same duration at the prevailing interest rate unless you give them other instructions within a week or two of maturity.

If you are investing a large amount in CDs, $100,000 or more, you could have to spread the investment among several institutions to make sure it is fully covered by FDIC insurance. Each investor is covered up to a total of $100,000 on deposit with each FDIC-insured institution. Retirement accounts are covered up to $250,000.

Internet searching, however, could lead you to some CDs that stray so far from the old, reliable, guaranteed-return model described above that it's reasonable to wonder whether they should still be considered CDs.

EverBank.com is one of a few institutions offering such "structured products." Among the offerings are MarketSafe CDs, which have a minimum investment of $1,500. They guarantee a return of the investor's principal but tie returns to gold or silver prices. If an index of the precious metal's price rises, the investor's return reflects that increase. If the asset falls, the investor could earn zero return.

EverBank also offers CDs, with a minimum investment of $10,000, that are tied to a variety of foreign currencies. Investors can lose principal on these CDs if currencies lose value compared with the U.S. dollar.

Bob Rockwell, a certified financial planner with Cambridge Investment Research in Sandy, Ore., says such instruments allow clients an economical, relatively low-risk way to speculate in normally risky investments, but he prefers a well-balanced portfolio of investments in stocks, bonds and cash-equivalents such as CDs or money-market instruments. "It's an investment for somebody who wants to dabble," he said.

McBride, at Bankrate, says he's not a big fan of them, either. "The investor may view that as having your cake and eating it, too," he said. "But you're getting a pretty small sliver of cake."