Certificates of deposit: it pays to shop around

Nation's Business, July, 1989 by Paul N. Strassels

Certificates Of Deposit: It Pays To Shop Around Buying certificates of deposit is the rage these days. Many investors still consider the stock market too risky for long-term investment. Small investors are reluctant to sink their retirement nest eggs into anything other than low-risk CDs. While you won't make a killing by buying CDs, you will sleep well and earn a respectable return on your money.

If, that is, you get the best deal.

Unfortunately, the terms offered by banks, savings and loans, and credit unions, in a given locality as well as nationwide, are anything but uniform. That makes it difficult to compare one CD with another.

Yet you should compare CDs--not just their interest rates but also how that interest is compounded, what penalties are levied for early withdrawal, and more.

When looking at interest rates, understand what's being offered. Is it simple interest? That is the annual percentage rate paid on the CD, without any compounding. At a given rate, you can't get any lower yield than with simple interest.

The annual effective yield (or annual yield) is a key number. This is the actual annual return after compounding. If the annual effective yield is 9.25 percent, a $10,000 investment will be worth $10,925 after one year.

The more frequently your interest is compounded, the more you will collect when you CD matures. Typically, interest may be compounded annually, semiannually, quarterly, monthly, or daily. But you have to ask. Never assume that your bank computes its interest the same way on all investments. It may offer monthly compounding for certificates of 24 months or more but only simple interest on CDs of six months or less.

The best way to compare interest yields is to ask each bank where you are considering the purchase of a CD to calculate the amount of interest you will earn over the term of the investment. There can be substantial differences, especially if you are investing a significant amount over a long period of time.

For example, you can earn, on a $10,000 one-year investment at 9 percent, $900 in simple interest, $920 when interest is compounded semiannually, $931 with quarterly compounding, $938 with monthly compounding, and $942 when interest is compounded daily.

There's more to selecting a CD than simply comparing interest rates. Premature-withdrawal penalties vary from bank to bank. Be clear on what the penalty entails before you invest in a CD. Some require that you forfeit a couple of months' interest. Others may take enough money to cover their cost of finding a replacement investment. That's a steep price to pay.

There are other terms to consider. Can you add amounts to your CD during the term and earn high interest rates on that money? What happens when the CD matures? Will it automatically be rolled over into a similar instrument, held without interest, or placed in a passbook account? Will you be notified prior to the CD's maturity?

Keep in mind that the best terms may not be offered locally. To maximize your return, you may have to purchase CDs from creditworthy banks in other states.

Check the financial pages of the newspaper to determine competitive rates. Or call your local investment broker, who can purchase CDs for you. The commission is small, and the convenience may be worth the cost. Another plus to purchasing a CD through your broker is that if you need to cash it prior to maturity, you can instruct your broker to sell it to another investor rather than redeem it at the bank, so you won't suffer that stiff premature-withdrawal penalty.