Stated vs. APY CD Rates

Investing in CDs may seem like a very straight forward process, but to be a well informed CD investor involves understanding the most important component of a CD, its rates. When you are ready to invest into a CD, you will often notice that there is both a stated rate and an APY. Yet, many investors are not aware of the difference in rates of how they affect them. While both are important, it is important to be able to distinguish the actual CD rate being purchased, as this will affect the return of the entire portfolio.

Understanding Stated CD Rates

The stated interest rate refers to the interest rate of the CD expressed as a per year percentage. Why is this important when it applies to CD rates? This rate expresses the total interest rate for the CD, not taking into consideration the effects of compounding. The stated CD rates are often greater for those with longer maturity dates.

For example, the 1 year CD rates will be lower than the 5 year CD rates. The primary reason for this is to pay the investor for the bank’s opportunity to keep their investment for a longer period of time. If shorter term CD rates are higher than longer term CD rates, this is typically a sign that the economy is worsening and is referred to as an inverted yield curve. Overall, the higher interest rate will be often more attractive to the majority of investors, although the longer maturity date and reduced flexibility should be taken into consideration.

Annual Percentage Yield (APY) Interest

The annual percentage yield (APY) refers to the true annual rate of return for an investment, including CDs for a specific year. An APY takes into account the effects of compounding on the interest rate. Compounding refers to the ability to make earnings on your earnings on an annual basis. The APY is generally higher for investments which have interest payments on a more frequent basis. Many investors consider the APY to be the ‘real’ or actual interest rate earned on an investment.

For example, if you purchase a $10,000, 5 year CD with a rate of 5%, you will have an interest payment for the first year of $500. However, the effects of compounding apply and the 2nd year, the interest paid will be based upon the $10,500 amount, not the initial $10,000 principal, yielding an amount of $525 to be paid in interest. Therefore, the balance in the investor’s CD account at the end of the 2nd year will be $11,025, continuing to grow until the maturity date of the 5 year CD.

Both APY and stated interest rates are important when considering CD rates to purchase. The most important thing to consider when it comes to the differences between a stated interest rate and an APY is that the investor will come ahead when they purchase CDs that take into consideration the compounding interest. Be sure to compare CD rates and issuers so that you can make the best investment selection for your personal needs as possible.

Pros and Cons of CD Investing

Investing into any investment vehicle will present both advantages and disadvantages to an investor. Both should be considered when evaluating options for an investment portfolio so that the products and services selected are the best possible match for the investor’s financial goals, time frame and risk tolerance.

Advantages

Fixed Investments- One of the most attractive things about a CD investment is that they offer a fixed rate of return, attractive to many different kinds of investors. Conservative investors as well as those who are seeking income are often the most suitable investors for CDs.

FDIC Insurance- For many investors, having the backing of insurance for their investments is attractive. Most CDs are backed with FDIC insurance, protecting investors in the event that the financial institution issuing them was to go bankrupt.

Maturity Date Choices- CDs are offered with a variety of maturity dates, ranging from one month to 5 years. The maturity dates offer differing CD rates to investors, with the longer maturity dates typically offering the investor the higher rate.

Income Possibility- In addition to conservative investors, those who are interested in a fixed income stream are often attracted to CDs. A common strategy that is utilized by investors to create ongoing income is called a CD ladder. A CD ladder involves purchasing CDs at varying maturities on an ongoing basis, so that after a year, CDs are maturing regularly. The investor will receive their original principal investment plus the stated interest upon maturity.

Simplicity- CDs are attractive investments to those who want simplicity as they are easy to invest into and require little to no maintenance until their maturity date.

Disadvantages

Zero Coupon CD Taxation- While there are many advantages to a zero coupon CD, one of the disadvantages is that the phantom interest income, not received until maturity, is taxed annually. Investors need to be aware of these annual taxes so that they can set aside the income to pay them when they are due.

Callable CDs- Investors are often attracted to these CDs for their higher CD rates, however they carry the risk of being called before their scheduled maturity dates.

Withdrawal Penalties- Due to the nature of penalties, often associated with the forfeiture of interest, CDs are often not good investment choices for investors who have the possibility of needing the capital prior to the CD maturity dates.

Low Interest Rates- While CDs offer higher rates than many other forms of cash investments, their interest rates are often substantially lower than other fixed investment options and equity investment options. It is important to take these rates of return into consideration when designing an ideal investment portfolio.

Inflation Rate Risk- One of the largest external risk factors to investing into CDs is inflation risk. Inflation risk refers to the risk of eroding purchasing power over time. While interest rate payments are fixed with CDs, it is important that they will out pace inflation so that an investor does not lose purchasing power during the investment period.

Understanding Brokered CDs

While an investor may be familiar with a CD as an investment, they may not be familiar with a brokered CD. A brokered CD is an investment option offered by a financial intermediary. When considering this investment option, it is important to understand what they are, how to purchase them and what considerations to have to create the best investment situation possible.

One thing to understand about a brokered CD is that they are brokered by financial professionals, meaning that the professional is searching the investment landscape for the best CD rates possible for investors. They are similar in concept to a CD that would be purchased at a bank, as they will pay a certain interest rate for the money deposited during the specified investment time period.

Features of a Brokered CD

There are some unique characteristics to become familiar with in regards to a brokered CD, including:

• Investing into a brokered CD is an effective way to open up the selection field to a larger selection of issuing banks. For investors searching for the best rate on their own, this can cut down the time spent visiting local banking institutions or the personal time that it would take to search for CD rates online.
• As brokered CDs are more similar to other fixed investment types and are in less supply than a traditional bank CD, the minimum purchase amount is often greater than the common $1,000 minimum that is often seen in a bank.
• While there is not a great deal of trading volume, brokered CDs can actually be traded in the secondary market. In some cases, this can allow for some flexibility in exiting the investment.

Buying Brokered CDs

If you are interested in brokered CDs for your investment portfolio, you are likely wondering where you may find them. You can locate brokered CDs through financial advisors or brokers in your area as well as financial planners or financial consultants. There is a wide variety of options available to purchase brokered CDs. When you select a professional to work with, be sure to interview several in order to find one that is best suitable for your personal and financial objectives.

Brokered CD Fees

Both traditional and brokered CDs have associated fees, generally taken out of the interest rate offered to the investor. While in most cases there is not a separate or up front fee for purchasing a brokered CD, there are some instances in which there may be an account fee associated with the method to purchase the brokered CDs. Be sure to inquire with the financial institution that you are purchasing the brokered CDs from if there are any applicable fees or charges so that you are not caught off guard if you notice anything on your financial statement.

Brokered CD Risk

The most significant investment risk associated with brokered CDs is that of market risk, as the supply and demand factors of the economy can affect returns. However, this risk only applies if the investor chooses not to hold their investment until its maturity and is forced to sell it in the secondary market.

Why Should I Invest Into CDs?

CDs (certificates of deposit) are a well known investment, utilized by investors around the world. Just like most any type of investment, there are advantages and disadvantages that should be taken into consideration when building a personal investment portfolio. Some of the advantages to consider of investing into CDs include: liquidity, CD laddering, current income, preservation of capital, and FDIC insurance.

Liquidity

One of the most significant benefits to investing into CDs is the overall liquidity. Investing into CDs often gives investors the ability to gain access to their cash in the event of a short term need, without paying significant penalties. While there are generally interest rate penalties for early withdrawal, many investors will stagger their CDs so that they have less of a chance of paying a penalty if they need access to their capital.

One of the methods for creating additional flexibility for their capital is to create a CD laddering strategy. CD laddering is a strategy that involves purchasing CDs with different rates and at different maturity dates. This creates a method where CDs will be maturing on a regular basis. This will present the opportunity to have access to capital on a regular basis without early withdrawing penalties. If the investor does not need access to their capital, they can simply reinvest it into a new CD when it becomes mature.

Competitive Cash Rates

CD rates are generally higher than most other savings products or cash products offered by banking institutions. Other common cash products include savings accounts, checking accounts and money markets. For investors who have extra cash on hand and who desire to earn a higher interest rate, CDs are an excellent option for consideration.

Preservation of Capital

Another primary reason why CDs are popular investment choices is that on top of the CD rates being paid to investors, the capital investment will also be returned to the investor at the CD’s maturity date. For conservative investors who still seek interest rates that are competitive along with security of capital, CDs are an excellent choice. The protection that is offered for investors is provided by FDIC insurance, insuring that in the event that the bank closes, the investor will have their investment returned to them.

Current Income

Many investors leverage CDs as an investment choice for current income. While CDs do not provide consistent income during the investment period, they do provide interest upon the CD’s maturity date. So, when the CD becomes mature, the investor will gain their original capital investment along with their earned interest. In order to receive regular income from CDs, a common strategy that will be used is to ladder CDs with different maturity dates and different interest rates. For example, if an investor purchases $1,000 CDs each month over 12 months, they will then have one maturing each month moving forward. This strategy can allow an investor to have regular interest income, to reinvest the capital into another CD or to withdrawal the entire investment amount when the CD becomes mautre.

How to Find the Best CD Rates

When investing into CDs, the most important factor that many investors often consider is the interest rate. While interest rates regularly change, it is important to understand where and how to find the best rates for your personal portfolio. Shopping around, using the benefit of time and working with relationships can help investors to take advantage of the best CD rates.

Shop Around for Interest Rates

The best place to start when working to locate the best CD rates is to determine what the current rates are. You can begin your CD rates search in the local paper, under the financial section. You can also visit many of the online investment websites, bank websites or general information websites for the average CD rates. Typically these resources will list the 1 year CD rates, the 3 year CD rates and the 5 year CD rates even though there are more available options to consider.

Once you have established a baseline, it is best to shop CD rates among several institutions. Banks are the best place to start and if you have an established banking relationship, begin your search there. In addition to finding out what the CD rates are at multiple banking institutions, you may also decide to search several of the more prominent brokerage houses. In addition to banks and brokerage houses, investors can also search online. With the expansion of the Internet as a search tool, there are a variety of additional banking and financial institutions that offer CD rates that are often times more competitive than what an investor can find locally.

Use the Benefit of Time

CD rates will most generally be higher for those with longer maturity dates. The primary reason for this is that the risk to the investor is higher than for shorter term CDs, and the investor is promising to leave their investment money with the financial institution for a longer period of time. The higher interest rate is a reward for taking both of these risks. If it is possible for an investor to take advantage of the higher long term interest rates, and/or to develop a CD laddering strategy, this is advised as it will increase the overall yield of the investment portfolio.

Leverage Financial Relationships

Another major factor to take into consideration when shopping for the best CD rates, is to leverage the power of relationships. If there is a pre-existing financial relationship, it is not uncommon for that relationship to offer a bonus rate for additional investment money flowing into their establishment. The reason for this is that many businesses are looking to add on products and services for existing customers, so they offer s bonus rate for the addition of a CD investment. So, next time you are looking for the best CD rates available, start by speaking with your local banking institution; you never know, you may just gain an extra portion of a percentage point or even an entire percentage point by taking this step.