Certificates of deposit are a low-risk way to save and invest your money through banks, credit unions, brokers, or lenders.
You might not have heard much about these investments since you were a kid and your grandparents gifted you the wrong kind of CD — the nonmusical kind — for your birthday. These vehicles made a small comeback in recent years as interest rates started looking up and investors once again stood to earn a solid return on their savings.
And although the fallout of the coronavirus pandemic caused interest rates to drop to historic lows in 2020, CDs may stand to regain some of their luster as the economy rebounds.
Before you decide where to allocate your money, learn the basics of certificates of deposit and how they compare with other types of savings accounts.
What Are Certificates of Deposit?
A certificate of deposit (CD) is what’s known as a time deposit — a single lump-sum deposit you make with a financial institution and agree not to touch for a fixed term in exchange for interest paid on an agreed-upon date.
Effectively, a CD is a type of savings account-investment hybrid that comes with modest interest and extremely low risk. Your deposit is FDIC insured at a bank or insured by the National Credit Union Administration (NCUA) at a credit union, just like with a traditional savings account.
Because you agree to leave your money with the institution for a set period, CDs traditionally come with interest rates more akin to a fixed-income investment product like a bond rather than a savings account.
Initial Deposit
Opening a new CD is similar to opening a regular savings account. You agree to a principal — the one-time deposit — and the term.
Each institution sets its own minimum deposit for CDs, so check with your bank to determine how much you need to open a CD.
Maturity Date
When you open a CD, you agree to a fixed period of time you’ll keep the money in the account, called your term length. For example, your term length might be six months, one year, 18 months, or three years.
The end of your term is called the “maturity date.” That’s when you can withdraw your principal, and you get paid interest.
If you retrieve your money before the maturity date, you have to pay an early withdrawal penalty and forfeit potential interest earnings.
Interest Rates
CDs are attractive to some savers because of the potential for a higher annual percentage yield (APY) compared to other savings vehicles. CDs tend to come with higher interest rates than typical bank deposit accounts.
CDs typically have a fixed interest rate, although some products offer a variable rate. Savers appreciate fixed-rate CDs because they’re virtually a guaranteed return.
Pro tip: If you’re planning to open a new CD account, consider CIT Bank. They are one of our favorite online backs because they offer some of the highest APYs.
Types of CDs
Certificates of deposit are generally straightforward and vary mainly on the minimum deposit amount, interest rate, and term length. However, your financial institution might offer these typical variations in CD terms.
- Traditional CDs: These include a fixed interest rate with typical terms of one to four years.
- Brokered CDs: A brokered CD is sold by a brokerage firm instead of a bank. They often come with a higher rate of return and more flexibility, but higher risk.
- Bump-up CDs: A bump-up CD comes with the option to make a one-time increase in the rate of interest you earn. They usually come with lower initial yields than traditional CDs but can help savers take advantage of rising interest rates.
- Jumbo CDs: These CDs come with a high minimum deposit — usually around $100,000 — and offer a higher interest rate.
- Callable CDs: The terms of your CD might state that your financial institution can close the CD, return your money, and pay interest before your maturity date, starting on a “callable date.” It might do this if market rates change so that the bank can make more money issuing new CDs to someone else. When this happens, the bank pays you interest for the full term and closes the CD early.
- No-Penalty CDs: These products don’t charge you a penalty for withdrawing your funds early. They tend to come with shorter terms, around 12 months.
- Step-up CDs: This type of CD account starts with a fixed rate for part of your term, and the rate increases periodically throughout the rest of the term. These products are rare, so you might not find the option with your bank.
CD Ladder Strategy
One risk with long-term CDs is that you miss out on a higher interest rate if the economy — and, therefore, market rates — increase over time.
To avoid missing out but still benefiting from the security of CDs relative to investing in the stock market, some investors use a strategy called “laddering” with CDs. It involves opening several CDs with different maturity dates, then reinvesting the money into a longer-term account at each maturity date.
So, for example, if you have $15,000 to invest, you could invest $5,000 each into a one-year CD, a two-year CD, and a three-year CD.
After one year, you’d withdraw your money and interest from the one-year CD and reinvest it into a new three-year CD. If interest rates have gone up in that year, you’d reap the benefit and get the higher rate for the new term.
After two years, you’d do the same with the two-year CD, and the same with the three-year CD after three years.
This strategy protects you from locking in a potentially lower interest rate for your entire $15,000 investment for three years and usually yields higher returns on average.
CD Alternatives
A CD account is just one of many financial products designed for short- or long-term saving. To get the most of your money while mitigating some risk, consider spreading your savings across several products that cater to distinct financial goals.
- Savings Account: A traditional savings account holds your money at a bank or credit union. These accounts typically yield low interest, between 0.01% and 0.10%, but offer more liquidity than CDs. High-yield savings accounts may offer more favorable — but still modest — yields. You can withdraw from a savings account without penalty several times per month, based on limits set by your bank.
- Money Market Account: A money market account works a lot like a savings account. This type of deposit account tends to yield interest and restrict withdrawals similar to a savings account, but it comes with a debit card and checks, so withdrawals are easier.
- Individual Retirement Account (IRA): This long-term retirement account comes with tax advantages and a potential for higher returns because it gives you the ability to invest funds in the stock market and other securities. It also comes with higher risk because your deposits aren’t FDIC-insured and are subject to potential losses.
Either a savings account or money market is a better place than a CD account for your emergency fund and short-term savings — like funds for a vacation or major purchase — because the money is retrievable whenever you need it without penalty.
The tax breaks you get for contributing to an IRA, combined with the likelihood of a solid return in the long run, make this type of investment account — as well as other retirement accounts like 401(k)s or 403(b)s — the best place for your long-term retirement savings.
A CD falls in between. You should invest in CDs with money you won’t need to access for the next few years for a safe and nearly guaranteed return.
Final Word
Tons of financial products exist to help you maximize your money throughout your life. Which are the best for you depends on your financial goals.
Certificates of deposit tend to be a moderate-return, low-risk product to invest your savings. They present the best opportunity for savers when the financial market is doing well and interest rates are high.
When CD rates are favorable, they offer a near-guaranteed return on investment at a higher rate than traditional savings and with much lower risk than the stock market.
Shop around for the best fitting terms on a CD, and check the fine print on your account before opening. You may be subject to account closing if the bank fears dropping interest rates, and you may face fees for withdrawing your funds before the end of the agreed-upon term.
Compare CDs with other types of savings accounts to make sure you allocate your money to fit your financial goals. CDs generally aren’t the right place for the bulk of your savings. Consider more liquid accounts for emergency funds you might need to access quickly, and tax-advantaged retirement accounts and other investments for long-term savings.
Source: moneycrashers.com
