WTF Is a Certificate of Deposit?
Certificates of deposit, or CDs, are the third leg of a trifecta of low-risk, low-return savings products offered by banks and credit unions. Like savings accounts and money market accounts, CDs are safe and easy to use.
That said, CDs offer much higher interest rates than those products, so you can grow your money faster. The hitch? You must agree to lock away your money for a specific time period, which can be months or years. In most cases you may access your money, but you’ll face a costly penalty.
How Do CDs Work?
The system is simple. You can open some CD accounts with no initial deposit. Go to any bank website and you’ll find offerings for several different CDs.
For each one, you’ll see the interest rate, which is typically compounded monthly. That means if you invest $1,000 in January and earn $5 in interest for the month, you’ll now have $1,005 earning interest in February, and so on.
Also, that interest rate will be expressed as the annual percentage yield (APY), or the rate of return over a year accounting for compounded interest. Then there’s the CD term, or the length of time you keep your money locked up. Terms can run from one month to 60 months. The longer the term, the higher the APY.
Lastly, each CD carries a maturity date. This is the time when you must decide to either cash out or roll over the maturing CD into a new one. If you pull out your money prior to the maturity date, you’ll be slapped with an early-withdrawal penalty, among other sanctions.
The Different Types of CDs
Besides the typical CD that offers a fixed interest rate and maturity term, CDs come in three other forms to give investors more options.
Some banks offer liquid CDs, which are commonly called no-penalty CDs. What’s nice about this type is that you can pull out your money at any time without being penalized. You also have the flexibility to take your money and reinvest it in a CD paying a higher interest rate. But there’s a trade-off: Rates for liquid CDs can’t compete with those for regular CDs.
The second type is called a bump-up CD. This one allows investors to move their money without penalty from an existing account into a new CD carrying a higher rate. Of course, as with the liquid CD, the downside is that you must accept a lower APY.
The third type is called a brokered CD, which is a bank-issued CD sold to investors through their brokerage accounts (retirement and taxable). The attraction is that compared with standard CDs, brokered CDs carry better interest rates for the same terms. Plus, brokerage firms offer clients access to hundreds more CDs than they could ever find at their local bank.
However, many brokered CDs have one major problem. Namely, money held in these accounts aren’t insured by the Federal Deposit Insurance Corporation (FDIC). The agency will back deposits of up to $250,000 in a savings account, money market account, or standard CD. But some brokerages offer FDIC-insured CDs with competitive rates and minimal penalties for early withdrawal.
Are There Any CD Investment Strategies?
Well, there’s the universal strategy of seeking out and securing that golden CD that offers the best rates with the best terms. More like wishful thinking.
CD investing is about having access to the highest APY rates possible for FDIC-insured savings products.
But investors give up access and flexibility with their money to secure those higher rates.
There’s one strategy you can use to earn the best rates while enjoying access to your money if you need it for an emergency or other urgent event. Under the CD laddering strategy, you can open multiple CDs that mature over the course of several months or years. Each time your CD matures, you can either cash out the money or purchase a new CD that pays a higher interest rate.
How the CD Laddering Strategy Works
Let’s say you have $10,000. Instead of sticking your cash in just one CD, you spread out your money among five CDs with descending terms. You put $2,000 each in a five-year, four-year, three-year, two-year, and one-year CD.
When the one-year CD matures, you then take your initial $2,000 plus interest and purchase a new five-year CD. When the two-year matures a year later, buy another five-year. Just keep the process going year after year. Eventually your ladder will consist of only long-term CDs earning some the best interest rates.
What makes this ladder effective is the blessing of compounding interest and rising interest rates. When interest rates are falling, however, the best strategy is to buy short-term CDs. That way, you won’t lock yourself into a low-interest CD for several years.
The Downside of Investing in CDs
To recap, the biggest negative with CDs is the early-withdrawal penalty, the severity of which varies from bank to bank.
In some instances, the bank will take back all the interest it paid you. Be aware that the CDs offering the highest interest rates usually impose the biggest penalties. But on average the early-withdrawal penalty is less severe. A CD with a maturity of a year or more typically translates into a loss of six months’ worth of interest.
This penalty is caused by another drawback with CDs: Your money is locked away for a specific period. You agreed not to touch it until maturity.
Locking your money away for, say, five years may result in inflation risk. This is what happens when your CD’s APY pays you less the rate of inflation (currently 2.3 percent). It happens. Inflation rates can and do spike well above the average APY offered by standard CDs. Keep in mind that with inflation, your savings lose their purchasing power over time if your APY gains don’t outperform the rate of inflation.
One of the Best Savings Tools
In other columns, I’ve have discussed the pros and cons of savings accounts and money market accounts, and how these savings tools compare with CDs. No doubt, CDs offer the best interest rates. But do you want to wall off access to your money for a few years?
I’m a big fan of parking your cash in both savings accounts and CDs.
Back in mid-2000s, when interest rates hovered around five percent for your standard online savings account, I decided to take a portion of my savings to purchase a couple of short-term CDs (no laddering) that paid higher rates. I figured it made no sense to keep some of my money in a lower-paying savings account.
I had no plans to spend nor invest that money in the stock market for at least a year, so I stuck to this plan for about two years. However, I eventually pulled the plug when interest rates began to retreat during the Financial Crisis of 2008–2009. The S&P 500 Index had fallen 50 percent, so depressed stocks seemed like a great place to invest some of my savings.
But now, interest rates today are rising again after a 10-year lull, as the stock market’s prospects start to dim. CDs would seem like a sensible and smart place to park your cash for the time being.