Raise your hand if you’d like to make a guaranteed investment, one you can be absolutely sure will maintain its value and interest rate.
Thought so! Me too.
While stocks are never a sure thing and even your savings account’s interest rate changes from time to time, a certificate of deposit (CD) offers a guaranteed rate of return. The interest rate offered at the time of purchase is in effect the whole time you hold that CD. The Wall Street Journal says CDs “are among the safest investment[s] a person can make” — as long as your bank is FDIC insured, your CD is covered up to $250,000. Even if anything happens to the bank, your money is safe.
Ready to learn more about CDs? Read on for our guide to investing in these financial products.
How Does a CD Work?
A CD is similar to a savings account in that banks want you to leave your money with them, so they offer to pay interest on the amount in your account.
Unlike your savings account, though, when you purchase a CD, you agree to leave your money in the bank until the agreed-upon amount of time has passed. The shortest CD offered is usually six months — though some banks offer terms as short as one month — and most banks offer one-year, 18-month, two-year, three-year, four-year and five-year options, while some offer even longer terms.
CDs come in a variety of types:
- Traditional: As described above, you receive a fixed interest rate in exchange for leaving your money in place for a specific length of time. Withdrawing your money before this term ends results in a serious penalty fee (up to six months’ interest, depending on your bank). This is the most common and popular type of CD. For example, GE Capital offers a 5 year cd at 2.23% interest rate.
- Bump-Up: Similar to the traditional CD, but if the bank’s interest rates rise during your CD term, you’re allowed one chance to switch to that higher rate.
- Variable-Rate: You won’t know ahead of time what the interest rate will be; instead, the rate is based on Treasury bills, the prime index or other market rates. It’s possible to earn more interest than with a traditional CD, but it’s also possible that interest rates could go down, decreasing your earnings.
- Liquid: Like a traditional CD, but you’re allowed to withdraw some of your money before the term is up. In exchange for this flexibility, though, interest rates on this type of CD are usually lower than any other type.
- Zero-Coupon: Rather than paying you interest, this type of CD reinvests it into the account, meaning you’ll earn interest on a higher total.
- Callable: The issuing bank can cancel your CD at its discretion, giving you back your deposit and any earned interest. The bank will usually only do this if interest rates fall far below the rate at which you purchased the CD.
- Brokered: Any CD you purchase through a brokerage, which often have access to higher-interest options.
To learn more about CDs, we spoke with Jennifer Calonia, editorial manager for GOBankingRates.com, a site that shares information on bank rates and investment strategies.
What Should You Look For When Choosing a CD?
“That really depends on your long-term financial goals,” says Calonia, echoing advice offered by the U.S. Securities and Exchange Commission.
“The first determination you’ll need to make is how long of a term to sign up for. Terms can range anywhere from a short, six-month span to five years or more, meaning your funds will be locked in the CD for that period of time,” she warns. While Calonia can’t recommend a specific length of time, she shares that “personally, I would stick to short-term CDs,” so she’s able to take advantage if interest rates suddenly start to rise.
Think about when you’re going to need the money in your CD. If you’re planning to go back to school in a year and will need that money for tuition, don’t lock it into a five-year CD, investment strategist Jonathan Hill told DailyFinance. Also, consider inflation risk — the possibility that inflation and interest rates could increase while your money is locked into a long-term CD, effectively costing you money.
If you’re planning to use your CD as an emergency fund, be wary. The disadvantage of having your money locked up in a CD, inaccessible until the term is up, may outweigh the little bit of extra interest you might earn, warns Jim Wang on Bargaineering. Instead, consider using a high-yield savings account, a truly liquid option, for your emergency savings.
“In addition to finding the right CD term for your needs, you should also be mindful about what happens to your funds once the account has reached maturation,” cautions Calonia. “Some financial institutions automatically roll over CD accounts into another term, which can mean lost earning opportunity if you planned on investing elsewhere.”
If you know you’ll want to do something else with your investment — like choosing a new term length as part of a CD ladder — make sure that maturation date is marked on your calendar in bright, bold marker.
Don’t base your entire investment strategy on CDs; they’re a safe complement to the rest of your portfolio, but should only account for about 5% to 10% of your investments, recommends DailyFinance.
All About Interest Rates
Prospective CD buyers should know two important numbers, The Wall Street Journal says:
- APR (annual percentage rate): The interest rate the bank is offering
- APY (annual percentage yield): What you’ll earn during the term of the CD due to compound interest
Need a refresher on compound interest? Here’s how The WSJ breaks it down:
What’s compounding? Put simply, it’s how your investment grows over time. Let’s say you invest $10,000 in a three-year CD earning 5% annually. In the first year, your $10,000 investment will earn $500. In the second year, 5% of the new total ($10,500) will be $525. In the third year, 5% of $11,025 will be about $551. The total amount of money grows each year, so the amount representing 5% of your investment also grows. That’s compounding.
GOBankingRates.com recently released a study where they asked Americans what interest rate would make them put their money in a CD for two years. More than half of respondents said they’d want 3.01% or better. While that expectation “is not the norm at the moment as the Fed continues to keep interest rates relatively low,” explains Calonia, “that may change as the economy slowly shows signs of recovery.” In addition, she notes, “there are a number of financial institutions offering more than 1.50% or more in returns, even for one year.”
Want to see what’s available? Rates are constantly in flux, but Get Rich Slowly put together a great post with weekly updates to CD interest rates.
One caveat: don’t base your final decision on which CD to choose on the interest rate alone. Even if two APRs are equal over a specific term, look at other factors: Calonia recommends considering “whether both institutions offer deposit insurance, how the interest is calculated (simple versus compound) and whether the interest rates are fixed (i.e. not variable, don’t have call option [not callable or bump-up]).” (Like this idea? Click to tweet it!)
What If You Need the Money Before the Maturity Date?
Calonia warns against withdrawing any money from your CD before the maturity date. “If you can avoid it, it’s best to not remove funds before your CD matures. Financial institutions impose a penalty for early withdrawals, which can be as much as 180 days’ worth of earnings; if you haven’t earned that much in interest, you’ll likely lose a bit of your principal deposit.”
If you’re worried about needing the money sooner than the maturity date, it’s best to make sure your choice of CD allows this option. “Some institutions offer ‘no-penalty (or liquid) CDs,’ which don’t apply a penalty fee for early withdrawal, but also doesn’t offer an interest rate as competitive as a traditional CD,” Calonia explains. If this kind of CD is more in line with your financial goals and situation, look into some of the options in this post.
Your Turn: Would you use CDs as part of your savings and investment strategy? If you do already, let us know about your experience in the comments!