Understanding Certificates of Deposit

They can be a great way to beef up your savings, but watch out for penalties.

CDs range from so-called time-deposit savings certificates -- available in modest denominations at banks, savings and loan associations, and credit unions -- to negotiable certificates requiring minimum deposits of $100,000 or more. They can be a great way to beef up your savings, but watch out for penalties. Here's what you should know:

With a CD, you promise to leave your money with the bank for the term specified on the certificate, which may be as short as three months or as long as five years. In return, the bank pays you a higher rate of interest than it would pay on an account with no such promise, and it probably charges a penalty if you withdraw your money before the certificate has matured. Usually, the longer the term, the higher the rate. Interest rates, penalties, and other terms vary from institution to institution. Be sure to get a clear explanation of what you'll have to pay if you redeem a CD early.

Also watch for the rollover provision. In some cases, the certificate will automatically be rolled over (that is, another certificate purchased for you) if you don't notify the institution within a specified number of days before the certificate's maturity.

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You can reduce the risks of a long-term commitment -- and take advantage of long-term rates -- by staggering, or laddering, maturities, so that some are always coming due in the near future. Then, if you don't need the cash, you can rotate the maturing certificates back into long or short maturities, depending on rates available at the time.

For example, if you have $2,000 to put in CDs, consider putting $500 each in a three-month, six-month, one-year, and two-year certificate. When the three-month CD matures, roll it over into a six-month certificate. Do the same when the first six-month CD matures, and continue rolling over so that you'll always have a certificate within three months of maturity.

To protect against getting locked into a low rate or being caught short of ready money, arrange to have the interest from some of the certificates paid out on a quarterly or semiannual basis. You will lose part of the extra return you'd get from compounding, but if rates are volatile, that's a relatively small price to pay for retaining your liquidity.