Certificate of Deposit (CD) Structure and Strategy

A solid cash management strategy serves as the cornerstone of any effective financial plan. With good cash management techniques, you can preserve liquidity and collect interest payments to pay bills on time, purchase big-ticket items, and acquire assets that can generate additional wealth. To meet these ends, you can put money into a certificate of deposit (CD). Before coordinating strategy, you should become familiar with the structure of the CD vehicle.

Certificate of Deposit (CD): Structure

When you take out a CD, you are actually lending money out to the bank. In exchange for your principal loan, you will receive interest payments until the CD matures. In most cases, you will earn a higher interest rate when you agree to tie up money with the bank for longer periods of time. The bank turns a profit when it borrows your cash and invests the money at a higher rate of return than your associated interest payments.

Be advised that you will owe penalty fees if you withdraw money from your CD prior to its maturity date. The bank discourages you from taking early withdrawals because it is reliant upon your CD as a steady source of capital to make investments.

Certificate of Deposit (CD): FDIC Insurance

As banking deposits, both CD principal and accrued interest are guaranteed by FDIC insurance. For 2011, the FDIC insures $250,000 worth of deposits per customer, per bank. As a large depositor, you will put money into multiple CDs at different banks to insure the whole amount. For example, you would divide $800,000 into eight separate certificates at eight different banks to protect the entire principal with FDIC insurance. If you were to put $800,000 into one CD, you would leave $550,000 without FDIC coverage.

Certificate of Deposit (CD): The Federal Reserve Board

The Federal Reserve Board works to manage the economy and the interest rate environment through its federal funds rate. Banks borrow money from each other overnight at the federal funds rate - to meet their Federal Reserve requirements. The federal funds rate is therefore a benchmark, or comparison standard, for certificate of deposit rates. Banks are willing to pay premium rates on CD offerings above the federal funds rate because they can borrow money for longer periods of time.

You can monitor average federal funds and CD rates through the "Wall Street Journal." In recession, the Fed generally lowers interest rates to encourage people and businesses to take out loans, purchase goods and services, and invest money. If you expect interest rates to fall, you can take out a long-term CD to lock in a favorable interest rate. Alternatively, the Federal Reserve Board hikes rates to protect a growing economy against inflation risks. At that point, you should consider a one-month CD. When the CD matures, you can roll the money into a new CD and take advantage of higher rates.

Certificate of Deposit (CD): Laddering

CD interest rates can be difficult to predict. To preserve liquidity and save for growth, you can employ CD laddering. CD laddering effectively diversifies your cash management portfolio, as you will be taking out certificates with different maturity dates. For example, you could put money into two separate one-month and one-year CDs. The one-month provides cash each month that can be reinvested to take advantage of higher rates. Meanwhile, the one-year CD allows you to lock in a good rate, if interest rates were to fall in the future.

Certificate of Deposit (CD) Structure and Strategy, Sources:

SEC: Certificates of Deposit

Federal Reserve Board: Purposes and Functions

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