A traditional savings account is a low-risk place for parking cash, but the interest on that money tends to be low. Certificates of deposit have many of the same low-risk benefits but higher returns.
Before purchasing a CD, it’s important to know how they work and where they fit in an investment plan.
Are CD’s a Smart Investment?
A certificate of deposit is a savings account with some distinct features. First, it holds a fixed amount of money, which a bank holds for a predetermined amount of time ranging from a few months to a few years. During this period, individuals earn interest on the money invested in the CD.
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.
CDs 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 a CD means the money is usually locked up until it reaches its maturity date. Withdrawing the money before the CD is mature may trigger stiff penalties.
Before purchasing a CD, it’s best to look at its disclosure statement, which should tell you the interest rate, whether the rate is fixed or variable, how often interest is paid, the maturity date of the CD, and any early withdrawal penalties.
Benefits of CDs
CDs are generally considered one of the safest options for investment. 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. This limit extends to each bank a person uses.
Higher Interest Rates
The average savings account interest rate in late 2020 was a hair under 0.1%, which is much lower than some other investments and may not even keep up with the rate of inflation. Average CD rates are four to six times greater than traditional savings accounts, depending on the term and how much is in the account. Average rates for one-year and five-year CDs in November 2020 were 0.24% and 0.41%, respectively. For jumbo CDs (those usually entailing a $100,000 minimum deposit), average rates were 0.27% for a one-year CD and 0.42% for a five-year.
Additionally, 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.
Wide 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 account options to choose from. For example, some banks offer CDs that have no penalty for early withdrawals, which could be a good choice for people on the hunt for a bit of interest but still want access to their cash.
Drawbacks of CDs
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.
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.
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.
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.
Types of CDs
The constraints of a tradition—such as illiquidity and early withdrawal penalties—don’t make sense for everyone’s situation. As a result, banks offer a wide variety of CDs that can fit an individual’s needs closely. Here’s a look at some of the options available.
The no-penalty CD allows you to withdraw your money without paying any fees. You usually have to accept lower interest rates in exchange for this privilege, and must typically withdraw the entire principal from the CD, as partial withdrawals are not usually allowed.
No-penalty CDs function much like savings accounts, but individuals can lock in an interest rate without worrying that it will ever fall.
These CDs tend to offer some of the highest interest rates available—often over 1%. They are typically offered by online banks and usually don’t require a high minimum deposit.
Jumbo CDs usually have a minimum deposit of $100,000, though some may be lower. In trade for such a large deposit, banks will usually offer higher interest rates than those available through traditional CDs.
One of the drawbacks of traditional CDs is that when you purchase them you lock in the interest rate, and interest rates may subsequently rise. With a bump-up CD, you can request a rate hike, usually if the bank starts offering a similar CD at a higher rate.
The bump-up CD has a close cousin called a step-up CD, which operates on a fixed schedule for rate changes.
Traditional CDs have a fixed interest rate, meaning the interest rate you get on the date of your deposit is the same over the life of the CD. A variable-rate CD offers a rate that can change as interest rates move up and down. Those who think interest rates are likely to rise may consider this type of CD. However, it’s important to remember that if interest rates fall, an investor could lose out on return.
A brokered CD is a lot like a traditional CD but is purchased through a broker, typically in a brokerage account. This setup can provide access to a wide range of CDs from different financial institutions. As a result, individuals are not limited to the CDs their local banks offer.
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.
Add-on CDs allow multiple deposits to be made into the same CD over its lifetime, though the number of deposits may be limited. As with traditional CDs, buyers of an add-on CD will lock in an interest rate at the time of purchase. They can maintain that interest rate for each additional deposit.
This CD is issued by a foreign bank and is denominated in U.S. dollars. The foreign bank typically must partner with an American bank to issue the CD. Interest rates for Yankee CDs tend to be low, and there is usually a $100,000 minimum. It should be noted that Yankee CDs do not have the benefit of FDIC insurance.
CDs in an Investment Plan
The liquidity limitations of most CDs can reduce investors’ flexibility, especially when it comes to unforeseen spending needs that may occur a year or two down the line. Luckily there are strategies that can help provide flexible access to cash while avoiding the need to tap into a CD early.
Building a CD Ladder
When building a CD ladder, individuals purchase multiple CDs at the same time that have a series of sequential maturity dates. For example, say Joanna has $10,000 to invest. She could purchase five CDs, building a CD ladder that looks something like this:
• $2,000 in a one-year CD
• $2,000 in a two-year CD
• $2,000 in a three-year CD
• $2,000 in a four-year CD
• $2,000 in a five-year CD
After one year, the first CD reaches maturity, giving Joanna access to her principal and whatever interest she earned. At that point she has a choice: Spend the principal however she chooses, or pocket the interest earned and reinvest the $2,000 principal in a new five-year CD.
By continuing this process, she will never have to wait more than one year for a CD to mature and to gain access to $2,000 in principal plus interest. What’s more, after five years, every CD in the ladder will be a five-year CD, which likely carries the highest interest rate.
Not only does CD laddering allow more flexible access to cash, but it allows investors to take advantage of rising interest rates. And if interest rates should fall at some point, investors may remain protected as they still have money held in CDs that offer a higher rate.
The Bullet Strategy
CD ladders can be kept going indefinitely, but if you are saving for a big expense at a fixed time down the road, you may consider using the bullet strategy. When using this strategy, you start CDs at different times, but their maturity dates are all the same. For example, say Jonathan is saving for a goal five years from now. The first year he would buy a five-year CD, the second year he’d buy a four-year CD, and so on. At the end of five years, all of the CDs would mature, and Jonathan has access to his cash.
The Barbell Strategy
Individuals looking for short-term liquidity might want to consider the barbell strategy: putting some money in short-term CDs and the rest in long-term CDs. For example, an investor might put half of their money in one-year CDs and the other half in five- year CDs, skipping all the maturity dates in between.
This strategy can work well for people who don’t want to tie up all of their cash but want to take advantage of short-term CDs if rates are high.
If long-term rates on CDs head higher, barbells can be turned into CD ladders at any point.
CDs can form part of a diverse portfolio that includes stocks and bonds. Diversification spreads your money out—across stocks, bonds, real estate, and beyond—in a way that matches your goals and tolerance for risk.
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