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Dubai: When looking at a safe means to invest in an uncertain environment or just to ensure that you have enough saved up for a rainy day, instead of setting aside idle cash that won’t get you returns, there’s another option, apart from fixed and corporate deposits.

Certificates of Deposit (or CDs) are one such financial product that allows customers to earn a certain level of interest on their deposits if they leave the money untouched for a certain period.

When you think about the business model of a bank, in the simplest form, it will take deposits from individuals who do not need the money right now. The bank keeps the money secure and lends out a portion of the money to other people who need the funds. In order to entice people to deposit their money, banks will pay a certain level of interest.

How does a CD work?

When a customer opens a CD account with a bank, he or she invests a specific amount of money for a set period. The bank pays interest at regular intervals until the date of maturity, at which time the account holder receives her original investment, plus all of the interest.

CDs come in varying terms and may require different minimum balances. The rate you earn typically varies by the term and how much money is in the account. In general, the longer the term and the more money you deposit, the higher the rate you are offered. (A longer term does not necessarily require a larger minimum balance.)

So, a CD with a shorter maturation time will offer you a decent return, but it pays to invest in a longer-maturing CD, which usually has a higher yield.

How should you choose a CD?

There are a number of factors to consider when choosing a CD.

First, when do you need the money? If you need it soon, consider a CD with a shorter term. However, if you’re saving for something five years down the line, a CD with a longer term and higher rate may be more beneficial.

Also, consider the economic environment. If it seems that interest rates may rise, or if you want to open multiple CDs, ‘CD laddering’ can be a good option.

What does it mean to build a ‘CD ladder’?

Overall interest rates may change during your CD’s term. If rates rise, you miss out on earning those higher rates, since your money is committed for the CD’s term. However, if rates go down, you benefit: You still earn the higher rate that was offered when you opened the CD. CD laddering, buying multiple CDs of varying term lengths, can help address this concern.

It can also be a way for you to take advantage of longer terms (and therefore higher interest rates) while still giving you access to some of your money each year.

With a CD ladder, you divide your initial investment into equal parts and invest each portion in a CD that matures every year. Let’s say, for example, a person has Dh10,000. To build a CD ladder, he invests Dh2,000 each in a 1-year, 2-year, 3-year, 4-year and 5-year CD. As each CD matures, he reinvests the money at the current interest rate or uses the cash for another purpose. If he reinvests his money, he might choose a new 5-year CD, which would ensure he has one CD maturing each year as long as he continues laddering.

Key perks and risks of CD investments

CDs offer a higher yield than most savings accounts or other similar accounts, which is beneficial for those who do not need their funds at the present moment but would still like a safe yield from investment.

A certificate of deposit is not going to eat up your capital due to market volatility. It is a completely secure financial instrument with an assured sum at maturity, similar to traditional insurance. The money you put into your CD will continue to predictably increase and there is no risk of any loss. It is a highly secure short to mid-term investment.

Another perk is that when it comes to the market there are always brokerage costs for the delivery, buying and selling of shares. There are usually no additional costs associated with a CD. You only pay what you invest with some banks.

Also you can opt for monthly payouts, annual payouts, or a lump sum withdrawal of your CD at maturity. You can pick the duration and price you want to invest, although it has to fit certain parameters set by the bank. Tailoring the CD to your needs helps you get the most from it.

However, a key risk is that certificates of deposit are characterised by a lack of liquidity since they are locked in for a certain amount of time. Although they can be withdrawn earlier, it comes at a penalty. The penalty makes it very unattractive to withdraw the funds early.

Moreover, although CDs offer a higher yield than savings accounts, there are many other investments and asset classes that offer a higher yield, including most stocks and other types of bonds.

What is the difference between Certificate of Deposits (CDs) and Fixed Deposits (FDs)?

The primary difference between a Certificate of Deposit (CD) and a Fixed Deposit (FD) is that of the value of the principal amount that can be invested, as CDs are issued for comparatively larger sums of money than an FD. The maturity period of Certificates of Deposit ranges from 7 days to 1 year if issued by banks.

Another key difference between FD and a CD is that CDs are transferrable and cannot be encashed premature. The fact that CDs can be transferred makes it an instrument that can be traded in the money market. If you have bought CD and you desperately want cash immediately you can sell it off in the market.

You will obviously be quoting a price lower than it’s worth to be able to sell it. People with loose cash who want to take advantage of the discount may buy it. Basically people with money looking for returns for short duration can use CDs to make a profit.

Frequently Asked Questions (FAQs) when it comes to CDs

FAQ #1: What happens to my CD at maturity?

In the month or two leading up to your CD’s maturity date, the bank will notify you of the impending end date. Its communication will also include instructions on how to tell it what to do with the maturing funds. Typically, it will offer you three options.

You could either roll over the CD into a new CD at that bank. Generally it would be into a CD that most closely matches the term of your maturing CD. For example, if you have a 15-month certificate concluding, they would likely roll your balance into a new 1-year CD.

If not that, you could transfer the funds into another account at that bank, with options that include a savings or another account. Else you would withdraw the proceeds. They can be transferred to an external bank account or mailed to you in a paper cheque.

FAQ #2: Should I let my CD roll over (extension or transfer)?

As a general rule, letting your CD roll over into a similar CD term at the same institution is almost always unwise. If you still don’t need the cash, and are interested in starting a new CD, rolling it may be easier, but chances are you aren’t choosing means to maximum return.

While shopping around is imperative if you want to earn the top rate on your CD investments, the odds are low that the bank where your CD is maturing is currently a top-rate provider among the hundreds of banks from which you can choose a CD. It’s not impossible you’ll do well with a rolled-over CD, but the probabilities are against you, and shopping around is always your better bet.

FAQ #3: What if I need to withdraw my money early?

Even though opening a CD involves agreeing to keep the funds on deposit without withdrawals for the duration of the term, that doesn’t mean you don’t have options if your plans need to change. Whether you encounter an emergency or a change in your financial situation—or simply feel you can use the money more usefully or lucratively elsewhere—all banks have stipulated terms for how to cash your CD out early.

Beware: Early or premature withdrawals can cost you dearly

However, if you do choose to cash your CD out early, the exit won’t be free. The most common way that financial institutions accommodate a premature termination is by assessing an early withdrawal penalty (EWP) on the proceeds before your funds are distributed, according to specific terms and calculations that were set out in your deposit agreement when you first opened the certificate. This means you can know before you agree to the CD if the early withdrawal penalty is acceptable to you.

Most typically, the EWP is charged as a number of months’ interest, with a greater number of months for longer CD terms and fewer months for shorter CDs. For instance, a bank’s policy might be to deduct three months’ interest for all CDs with terms up to 12 months, six months’ interest for those with terms up to 3 years, and a full year’s worth of interest for its long-term CDs.

However, the above mentioned types are just examples—every bank sets its own early withdrawal penalty, so it’s important to compare EWP policies whenever you are deciding between two similar CDs.

It’s especially wise to watch out for early withdrawal policies that can eat into your principal or main amount. The typical EWP policy described above will only cause you to earn less than you would have if you would have kept the CD to maturity. You will generally still have earnings, as the EWP will usually only eat up a portion of your earned interest.

However, some particularly heavy penalties exist in the marketplace, where a flat percentage penalty is applied. Since this percentage can outweigh what you’ve earned on a CD you haven’t kept very long, you could find yourself collecting less in proceeds than you invested. As a result, these types of EWPs are best avoided.

Always check a bank’s early withdrawal policy before committing to a CD. If it’s especially aggressive—or you can find another CD with a similar rate and a milder term—you’ll be wise to stay away from the harsh penalties.

Key takeaways points

• Certificates of deposit mostly pays higher interest rates than the best savings and money market accounts in exchange for leaving the funds on deposit for a fixed period of time.

• CDs are a safer and more conservative investment than stocks and bonds, offering lower opportunity for growth, but with a non-volatile, guaranteed rate of return.

• Almost every bank and brokerage firm offers a menu of CD options.

• CD rates are typically three to five times higher than the industry average for every term, so shopping around delivers significant gains.

• Although you lock into a term of duration when you open a CD, there are options for exiting early should you encounter an emergency or change of plans.