A certificate of deposit (CD) is a deposit account that pays you a fixed interest rate over a set period. You can close a CD early and pay a penalty but the bank cannot close it (call it) early, unless it’s a very rare callable CD. CDs are nice because they often represent the highest safe return you can get since those deposits are protected by FDIC insurance.

However, when the difference between a 12-month CD and an online savings account is microscopic, you start to wonder if it’s worth the effort. I took a look at one a major online bank (I won’t say which because I don’t want to update these rates when they change, but they are a “friendly” bank and they have very good rates) and their high yield 12-month CD had a yield of 1.29% APY. Their online savings account offered a yield of 1.09% APY. While a 0.20% APY difference is large in relative terms, it’s tiny in real terms.

0.20% APY on $100 is 20 cents. By locking your savings into a 12 month agreement, you earn an extra 20 cents per $100. I’ll be the first to say that every little bit helps, but 20 cents isn’t going to cut it (this is before you carve out a few cents for taxes!).

It makes me wonder, in this era of high yield savings accounts with rates that rival certificates of deposit, have CDs been made obsolete?

As I was reviewing the CD rates of PNC Bank, after learning of PNC’s $100 checking account promotion, I saw that they offered a 36 and 60 month callable CD on their promotional rates page.

A callable CD is a CD where the bank has the option of closing it after the fixed period. The CD is usually “sold” as a fixed month CD with call protection, so a 60 month CD with 12 months of call protection. In that case you have a 60 month CD that the bank cannot call, or close, within the first twelve months. After the twelve months of call protection expires, the bank can close the CD if it chooses to. You, however, cannot. This shifts interest rate risk onto you, the depositor. If rates go up, you don’t benefit because you’re locked in. If rates go down, the bank can simply call the CD and you have no choice but to close it.

The payoff is in the rate. A callable CD will usually have a higher interest rate than a regular CD because the depositor is bearing the risk. In the case of PNC, the 36 month callable CD had a 2.00% APY yield while the 36 regular CD had a 1.15% APY yield. The difference for the 60 month CDs were even greater, with the callable yielding 3.00% APY and the regular yielding a mere 1.55% APY. By the way, according to our best CD rates, a 5 year CD currently yields at least 3.00% APY so don’t bother with PNC’s callable CD if that rate appeals to you.

(Photo: djbrady)

Until today, I don’t believe I’ve ever seen any online bank offer a bump up CD. A bump up CD is a certificate of deposit that gives you the option to increase the current rate of your CD to the published rate, “bumping” it up. If you remember my attempt at being cute with the Certificate of Deposit Zoo, it was the giraffe.

The biggest risk with long term CDs is inflation risk. If you open a two-year CD at 2% and inflation is 3% a year, you’ve effectively lost 1% of purchasing power on that money each year. While it’s better than being in a checking account earning 0%, thus losing 3% each year, your money is “stuck” unless you want to pay a penalty.

Bump up CDs take away some of that risk because they let you bump up the CD’s interest rate one time. Does that make a bump up CD a sure thing? No, but if you have the choice between two long term CDs with identical interest rates, it’s obvious that the CD with a bump up option is superior.

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Every once and a while I get an email from a reader that asks where he or she should invest $1,000.

My answer? An online savings account or a certificate of deposit.

Unfortunately, $1,000 just simply isn’t enough for you to invest in the stock market. It’s certainly not enough for real estate and it’s usually not enough for investing in any asset class.

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If you look at Ally Bank’s current rates, there appears to be a discrepancy in the way they’ve structured their rates. I tweeted about this last week and it appears the difference in rates has persisted through a recent rate drop, making it doubly curious. Let me explain what I mean.

As of today (June 22, 2009), here are the current rates of several of their products:

• Traditional 9-month CD: 1.75% APY
• No-Penalty 9-month CD: 2.15% APY
• Online Savings Account: 2.00% APY

Two things surprise me:

1. A traditional CD should never have a lower yield than a no-penalty CD of the same maturity. With a no-penalty CD, you have the right to close the CD before the maturity period without penalty. The bank can’t close it. You should be paying, through a discount on the interest rate, for that flexibility. When the no-penalty CD first debuted, its interest rate was a tenth of a percent lower than the traditional CD’s rate.
2. The no-penalty 9-month CD with a higher yield than the online savings account represents an opportunity. We’re in a period when rates on savings accounts and CDs are dropping. However, should rates ever make a turn and start rising, being locked into a CD might be bad news. However, with a no-penalty CD, I can close at anytime so the risk is minimal! There is no reason why someone should keep their funds in an online savings account when the same exact bank is offering a no-penalty CD option with a higher interest rate.

This morning I transferred all my funds from my Ally Bank online savings account into the 9-month no-penalty CD to get that extra 0.15% APY. If the two accounts weren’t at the same bank, I wouldn’t have done it because the transfer time would’ve cost me interest. However, anytime someone is willing to give me a $2 bill in return for a $1, I take it.

Is there something I’m missing?

For the longest time I thought a certificate of deposit came in one flavor – vanilla. I deposit some money into a CD, I wait until it matures, and then I decide whether I want to put it back in or do something else. Online banks offer better rates than traditional and you can get fancy by creating a CD ladder, but at the core a CD was a CD was a CD. Then I learned about Ally Bank’s no-penalty CD that lets you close a CD before its maturity without losing interest. OK, that was interesting, but it wasn’t all that exciting.

Then today, I read this Bankrate article about the different types of CDs and was surprised at all the options. I guess I had heard about several of them in the past but dismissed them as hokey (callable CDs? I’ve heard of callable bonds but never CDs). I think some of them are clever just to be clever (and so they can list more rates?) but overall it’s kind of a dry read… so I tried to make it a little more interesting.

How about we take a visit to the Certificate of Deposit Zoo?

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In mid-May, GMAC Bank changed its name to Ally Bank. With General Motors in the news every day for something negative, it’s hard to do business when everyone thinks you’re about to go out of business. The funny thing about it all is that GMAC Bank’s parent company, GMAC Financial, hasn’t been a part of General Motors for several years. When you have financial companies in distress and auto companies in distress, a bank that people think is inextricably linked to auto company is in some deep trouble.

So, they changed their name.

But are they a good bank to do business with? Let’s find out.

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When I first opened up my Vanguard account a few years ago, I requested all sorts of fancy investment brochures. I had just started Bargaineering and had a voracious appetite for financial information and fancy words like annuities, in all their flavors, really intrigued me because I had never heard of them. One of the books I requested was Vanguard’s booklet on annuities, an investment vehicle I would later learn is rife with ripoffs and unscrupulous characters.

I never read the booklet until my wife and I were cleaning out some documents and they remind me a lot of long term CDs, with a few wrinkles. If there’s anything I’ve learned in the last few years is that the financial community has a funny way of coming up with a million different ways to do the same thing, if only to be able to say they have a hot new investment option for you!

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