A certificate of deposit (or CD) has many of the same low-risk benefits as a savings account, but a CD holds your money for a fixed time period in exchange for a higher rate of interest than the standard savings account.
CDs can be used as a part of a portfolio’s cash allocation — and CDs generally pay a higher interest rate than you can get with other cash accounts. Owing to their lower risk profile and modest but steady returns, allocating part of your portfolio to CDs can offer diversification that may help mitigate your risk exposure in other areas.
If you’re wondering about how to invest in CDs, it’s important to know how they work and where they might fit in your investment plan.
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Are CDs a Smart Investment? 4 Things to Know
Investing in CDs can be a smart way to go, if they suit your goals. A certificate of deposit is similar to a savings account in that you can stash your money for a long period of time, but CDs possess some distinct features you need to understand in order to gauge whether they’re a good fit with your plan.
1. A fixed deposit for a set time period
First, you purchase a CD for a fixed amount of money: e.g., $1,000, $5,000, or more. Some banks have a required minimum deposit, others don’t. Generally, you cannot increase the amount of your savings (although you can always buy another CD). Some banks offer jumbo CDs, which might require a minimum $100,000 deposit.
Unlike a savings account, which is open-ended (and allows you to access your cash at any time), you typically purchase a CD for a set period of time during which you can’t withdraw the funds without a penalty. Typical CD terms can vary from one month to five years, so check with the institution that issues the CD.
2. Guaranteed interest rates and insurance
Because investing in CDs is less liquid than a savings account, the interest rate tends to be higher. CD rates are quoted as an annual percentage yield (APY). The APY is how much the account will earn in one year, including compound interest. (Banks generally compound interest daily or monthly.)
When the period is up, also known as the CD maturity date, the CD holder can receive the original investment, plus any interest earned.
As of December 2021, the average rate for a 1-year CD was about 0.51%; the average rate for a 5-year CD was 0.86%. But the interest rate can vary considerably, depending on the institution.
The money in a CD is protected by the same federal insurance that covers all deposit products, whether at a bank, credit union, or other institution.
3. Early withdrawal penalties
CDs can offer higher yields because customers are promising the bank that they will deposit their money for a set period of time. As a result, investing in CDs means the money is usually locked up until it reaches its maturity date. Withdrawing the money before the CD matures may trigger a penalty, which could effectively eliminate any interest rate gains.
The penalty for an early withdrawal on a CD is often stated in terms of interest: e.g. you would owe 60 days worth of interest, 90 days worth of interest, 150 days worth of interest, and so on. The penalty is usually charged according to the simple interest rate on your account, not the compound interest you might have earned over time.
Before purchasing a CD, it’s best to look at its disclosure statement, which should tell you the interest rate, how often interest is paid, the maturity date of the CD, and any early withdrawal penalties.
4. Terms vary widely
It’s important to shop around for the best CD rates and terms. Brick-and-mortar banks may pay lower rates, while online banks and credit unions may pay higher rates. Because the interest rates on CDs are based on the federal funds rate, similar to mortgages and other financial products, it’s also a good idea to see whether the Federal Reserve is about to raise or lower interest rates before deciding whether it’s a good time to invest in CDs.
Types of CDs: 6 Other Options
The details above describe the basic structure of a traditional CD, but there are a few other types that may offer features that are more desirable. In some cases, these may come with tradeoffs or additional risk factors, so be sure to weigh the pros and cons and terms of each.
1. Liquid CDs
If you’d prefer a CD that allows you to access your savings before the maturity date without paying a penalty, a liquid CD may offer a solution. These CDs don’t charge a penalty for early withdrawals, but they may offer lower interest rates as a result.
2. Bump-up CDs
Some investors dislike the idea of locking up their cash at a fixed rate, when in theory rates could rise, and you’d lose out on the higher rate of return. A bump-up CD may help address that concern by allowing you a chance to “bump up” to a higher rate.
3. Add-on CDs
Let’s say you don’t have the specific amount required to open a CD. Another option is to open an add-on CD, which allows you to make additional deposits.
4. Variable rate CDs
Like a variable rate loan, a variable rate CD doesn’t pay a fixed interest rate. This may give you higher or lower rates at some points, but the point is that the rate isn’t guaranteed, so you have to be willing to take your chances.
5. Uninsured CDs
If you’re willing to forgo federal insurance on your deposits, you might be able to get a higher interest rate.
In all cases, be sure to check the terms of the CD you’re about to buy, in case there are restrictions or caveats that might make a certain CD less desirable. For example, there are some CDs offered by foreign banks, but denominated in U.S. dollars, which may offer competitive rates but they are not federally insured.
6. Brokered CDs
A brokered CD is a lot like a traditional CD but is purchased through a broker, typically using a brokerage account. This setup can provide access to a wide range of CDs from different financial institutions.
It is also possible to trade brokered CDs on the secondary market. Finding a buyer may be difficult, however, which could mean accepting a lower price for the sale. Brokered CDs may come with additional fees.
CDs in an Investment Plan
Wondering how to invest in CDs? CDs can be incorporated as part of your financial plan in various ways. They can act as short-term savings vehicles — a way to secure your money for a down payment or a large purchase within five years, say. Or they can be part of a longer-term strategy. Here are some examples.
CD ladder
A CD ladder uses a combination of shorter-term and longer-term CDs to maximize different rates of return, and deliver several years of steady income. (Note: Some investors use a similar strategy with bond ladders.)
Hypothetically, let’s say you want to invest $10,000 over a 10-year period. You could create a CD ladder by purchasing five CDs of different maturities all at once, and reinvesting them as follows:
• Deposit $2,000 in a 1-year CD. When that CD matures, roll over the money plus interest into a 5-year CD.
• Deposit $2,000 in a 2-year CD. When that CD matures, again roll over those funds into another 5-year CD.
• Do the same for a 3-year, 4-year, and 5-year CD. As each one matures, you roll over the funds, plus any accumulated interest, into a 5-year CD.
The result will be five different CDs that mature one year apart, allowing you to withdraw your funds plus interest. This strategy ensures some diversification of interest rates, so your money isn’t locked into a flat rate for the full 10 years.
CD barbell
The CD barbell is like a CD ladder, but without buying any mid-length CDs: Here you invest a certain amount in a short-term CD (say 1 year), and the rest in a 5-year CD as a way to hedge your bets.
The barbell strategy allows you to take advantage of both short- and long-term rates. When the short-term CD matures, you can either reinvest at the short-term rate if that makes sense, or shift the money over to a longer-term CD.
Bullet CDs
Instead of buying a few CDs of different maturities at the same time, the bullet strategy allows you to invest different amounts at different times, as a way of saving for a specific goal like a down payment.
This strategy could allow you to invest one amount in a CD to start, save up more for a year or two and buy another CD that matures at the same time as the first, and so on. Then you have, say, three CDs that mature at the same time, with interest, allowing you to withdraw the lump sum from each one for your goal.
For example: You could invest $5,000 in a 5-year CD today. Then, in two years, invest $3,000 in a 3-year CD. Last, save up money for another two years and buy a $2,000 1-year CD. All three CDs mature at the same time–and you can withdraw all the money, plus compound interest.
Benefits of Investing in CDs
Investing in CDs can offer some investors specific benefits.
Peace of Mind
CDs are generally considered one of the safer options for investors. Like traditional savings accounts or high-yield savings accounts, CDs are insured for up to $250,000 when they are purchased through an FDIC-insured bank or an NCUA-insured credit union. If the CD-issuing bank failed, your deposits would be covered up to $250,000.
Predictability
CD interest rates are usually fixed and will deliver a predictable yield at the end of their term. The same is not necessarily true of traditional savings accounts, which may lower the amount they pay if interest rates drop. The ability to calculate exactly how much you’ll be paid at the end of the CD’s term makes it easier to know how that CD will fit into a financial plan.
A Variety of Options
Thousands of banks and credit unions across the country offer a diverse selection of CDs, which come with many interest rate options and with maturity lengths from a month to a decade.
There also may be different styles of CDs to choose from, as discussed above (e.g. bump-up CDs and add-on CDs). But, as always, be sure to check the terms.
Drawbacks of Investing in CDs
Of course, like any other investment CDs come with their share of potential risks and problems.
Illiquidity
One of the main drawbacks of a CD is that most of them are relatively illiquid. An investor’s money is tied up until the maturity date, and early withdrawals may trigger penalties in the form of lost interest payments or, in some cases, lost principal.
Though there are some CDs that offer penalty-free withdrawals, investors must often accept lower interest rates in trade.
When choosing a CD, it’s best to carefully consider a maturity date you know you will be able to meet. An emergency fund can help you avoid the temptation to tap CD investments when the unexpected happens.
Inflation Risk
Despite the fact that CDs tend to offer higher returns than traditional savings accounts, they can still be subject to the same inflation risk. When inflation is high, CD returns may be unable to outpace it. That means the money sitting in the CD may lose purchasing power before reaching maturity.
Taxes
When investors withdraw money from CDs after the maturity date, they pay no taxes on the principal withdrawn, but the money earned is taxable on state and federal levels as interest income.
The taxes will reduce the amount of money a CD investor will actually get to take home. It’s a good idea to carefully consider taxes when shopping for a CD and deciding on an APY.
Opportunity Cost
Money that’s tied up in a CD can’t be put to work anywhere else — a problem known as opportunity cost. CD interest rates may be higher than some other bank products, but stocks, bonds, and other investments may offer much higher returns. That said, higher returns are often associated with higher risk.
CD investors may be opting to avoid risk or using the accounts to diversify a portfolio that already holds a mix of stocks and bonds.
Is Investing in CDs a Good Fit for Me?
Investing in CDs may be a good fit for you if you’re looking for a relatively low-risk way to invest cash for a modest but predictable return.
Investing in CDs does require that you be able to tolerate certain constraints:
• Your money is typically not available until the CD matures (or you could incur a penalty).
• The interest rate is guaranteed, in most cases, but you may forfeit the option to invest at a higher rate.
• The opportunity cost of CDs is important to weigh: When your money is locked up in a CD it can’t be invested elsewhere for a potentially higher return. But if you invested in securities that might provide a higher return, these would likely come with additional risk exposure.
The Takeaway
Although CDs are sometimes dismissed as simple savings vehicles, in fact investing in CDs can offer a steady if modest rate of return, and some peace of mind — factors that may appeal to some investors, especially over time.
While investing in a CD means your cash is off limits until the CD matures, the money also grows at a predictable rate, making it easy to fit CDs into your financial plan. It’s also possible to combine CDs using different strategies like a CD ladder to create an income stream or maximize different interest rates over time.
When you think of CDs as part of your overall portfolio, they can offer some diversification that may help offset risk factors in other areas. Thinking of investing in more than just CDs? You can open an online investing account with SoFi Invest®, and start investing in stocks, ETFs, and even crypto. And as a SoFi Member, you would also have access to complimentary financial advice from professionals who can answer more of your questions.
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