When are CDs a good investment?
Key points to remember
- Bank CDs offer a fixed interest rate for a set period of time, with no market risk of losing the principal.
- Although yields have been low for some time, they are rising as the Federal Reserve raises interest rates.
- Using a CD ladder is a solution to overcoming many disadvantages of investing in CDs.
Are certificates of deposit a good investment? The answer to this question depends on several factors, including how long you’re willing to tie up your money and the current interest rate. The good news is that you can create a CD ladder to overcome some of the disadvantages of CDs. Here’s everything you need to know if you’re considering investing in certificates of deposit.
What are certificates of deposit?
A certificate of deposit is a type of savings product that generally offers a higher interest rate than a traditional savings account. CDs also have certain restrictions, such as a fixed term and early withdrawal penalties.
When you open a CD, you agree to leave your money in the account for a specified period. The most common CD terms are six months, one year, two years and five years. Longer-term CDs generally have higher interest rates than short-term CDs. The interest rate on a CD is fixed, which means it will not change for the life of the CD. It’s different from a savings account, where the interest rate can go up or down over time. The interest the CD earns accumulates in the account, and when it matures, you get your principal plus interest back.
Current rates for CDs
Yields on CDs rose with the Federal Reserve raising interest rates. If you search online, you will find the highest FDIC insured CD rates. For example, after a simple search I found online banks paying up to 3.56% for a six month CD and 3.50% for a 5 year CD.
It’s important to know that when the Fed raises interest rates, it takes time for the higher rates to trickle down to CDs and other savings products. Most of the time, when rates go up, the interest rate on debt products like car loans, mortgages and credit cards goes up immediately. Then, in a few days to a few weeks, the interest rate on savings accounts and certificates of deposit will increase. This is because interest on savings accounts and CDs is a liability for banks, while interest on loans is income.
The immediate increase in lending rates and the slow increase in savings deposit rates give banks a larger profit margin. Savings product rates increase over time because to issue new loans, banks must accept more deposits. A higher savings rate encourages people to save more.
So if you hear that the Fed has recently raised rates, you don’t need to rush out and buy a CD because it won’t have an updated rate for a few days.
Reasons to invest in CDs
There are several reasons to invest in CDs. CDs generally pay a higher interest rate than savings accounts, so if you want to earn more money from your emergency savings, CDs are an option. Likewise, if you are on a fixed income, as many retirees are, you may want to put some of your savings into CDs. Not only do you earn interest, but your capital is safe because its value will never decrease. It is insured by the FDIC. If you were to invest in bonds, there is a risk that the value of the bonds will fall.
Another benefit is that you know your performance and can plan accordingly. Before investing in a CD, you know the interest you will earn and you know how long it will take you to earn that money. This helps for planning purposes. If you need to earn a certain amount of interest to cover your living expenses, you can determine how much you need to invest using the interest rate.
With CDs, there is no charge. You can open a CD in person or online in minutes and at no cost. When you invest in bonds, you usually have to pay fees. This may be a trading fee for the broker, or for the mutual fund or exchange-traded fund as a management fee.
Finally, CDs give you the opportunity to roll over your investment. Most banks have auto-renewal in place, which means that when the CD expires, you have a set amount of time, like two weeks, to contact them and tell them you don’t want to renew. If you don’t contact the bank, they will reinvest your money in the same term CD. This makes the investment in this security completely hands-off.
Disadvantages of CDs
Of course, CDs also have disadvantages. The most important is the blocking period. When you buy a CD, your money is locked in for the duration. If you need money, you can redeem the CD earlier. However, you will pay a penalty, usually a few months interest. Some banks offer special CDs called penalty-free CDs that allow you to close the CD before the end of the term without penalty.
Another problem is that CDs don’t always pay a high interest rate depending on the economic environment. From 2011 to 2019, you were lucky if you earned 1% on a 5-year CD. Although this rate was higher than most savings accounts, it was not enough for most people interested in this product.
Speaking of interest rates, there is a risk when buying CDs in an inflationary environment. If interest rates rise and you buy a 5-year CD, you lock in the interest rate for five years. So if you buy a CD with an interest rate of 2% and rates go up to 5%, you only earn 2%. Of course, you can close the CD, pay the penalty and reinvest in a higher yielding CD. In response to this problem, many banks offer what is called a rate increase CD. This allows you to reset the interest rate to a higher rate once during the term if rates go up.
Bonds tend to offer a better return if you want to earn more from your money. If you invest in government-backed securities, such as treasury bills, you are investing in a risk-free asset. However, you risk losing some of your principal if interest rates rise, as bond prices will fall. This is only a problem if you invest in bond funds. If you’re buying individual bonds, that’s fine, unless you have to sell before maturity.
Finally, depending on the economy, the interest you earn might not keep up with inflation. This was the problem from 2011 to 2019. While inflation was moderate, between 2 and 3% per year, CDs were paying less than 1%, effectively costing you purchasing power. It didn’t make sense for many retirees and income seekers to invest in this security. As a result, many have invested in dividend-paying bonds or stocks, hoping to earn a steady stream of income. The problem here was that many were taking more risk than they should have to earn a higher rate.
Build a CD ladder
To overcome some of the disadvantages of CDs, many people invest in CDs using a CD ladder. This means buying CDs of different maturity dates, giving you access to your money and earning the most interest possible. For example, if you have $10,000, you can choose to invest $2,500 each in the following:
- A six-month CD at 3.00%
- An 18-month CD paying 3.92%
- A 2-year CD paying 3.97%
- A 5-year CD paying 4.05%
When the six-month CD expires, you buy a new 5-year CD. When the 18 month CD expires, you buy another 5 year CD. This allows you to continually earn the most interest while still being able to access some of the money if needed, as some will come due at regular intervals. If, when the six-month CD matures, you need money to pay your bills, you can do so without having to withdraw money from another CD and lose some of the interest.
If you put the whole $10,000 in a 5 year CD and you need the money, you can’t redeem part of the CD. You have to redeem everything, then pay the interest penalty and invest what’s left in a new CD. Using a ladder reduces the risk of paying the interest penalty for early termination, and you can earn more interest than if you put all the money into the shorter-term CD available.
How to Earn Higher Rates on CDs
If your bank does not pay competitive rates for CDs, you may want to look online, as online banks offer higher returns. But going through your broker is where you can get higher returns. Many brokers offer traded CDs, which often pay higher rates than those purchased directly from banks. As a bonus, there is no penalty for early withdrawal. This is because when you buy CDs from a broker, you are doing so in the secondary market.
Instead of buying from a bank, you are buying from another investor or institution. If you need to sell, you don’t close the CD. Instead, you sell to another investor. Although there is no penalty for early termination, most brokers charge trading fees, so this should be taken into account.
Certificates of deposit can be a great way for investors to earn a return while protecting their investment. The downside is that sometimes the interest earned doesn’t keep up with the rate of inflation, causing you to lose purchasing power. But when that’s not the case, strategic use of CDs in your portfolio can generate income while providing you with cash if you need it.
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