If you’ve been researching different avenues for saving and investing your money, you’ve likely come across the term “CD.” Let’s discuss what a CD is, how it can be used, and if it’s a worthwhile investment. We’ll also look at alternatives if you decide a CD isn’t for you.
What Is a CD?
A certificate of deposit, or CD, is an FDIC-insured savings product that offers a fixed interest rate for a specific term length. It’s an attractive option because of the guaranteed return. But if you withdraw your money before the end of the term length, you’ll have to pay an early withdrawal penalty.
Learn More: What Are “No Penalty” CDs?
CD interest rates vary widely depending on the term length, the bank, and the amount deposited. For example, Bank of America offers a CD interest rate of 0.07% for a $10,000 deposit on a 12-month term. Ally, an online bank, offers a CD interest rate of 1.05% for the same deposit on the same term length. You can visit ValuePenguin for average CD interest rates across the nation’s largest banks.
If you’re concerned about locking your money away for long periods of time or just want more flexibility in terms of being able to catch an increased rate, a CD ladder could be a good method for you. A CD ladder involves depositing money into smaller CDs with staggered term lengths, rather than depositing all your money into one long-term CD.
Here’s an example of a how to set up a CD ladder with $10,000 in total funds. You need to put:
- $2,000 in a 12-month (1-year) CD
- $2,000 in a 24-month (2-year) CD
- $2,000 in a 36-month (3-year) CD
- $2,000 in a 48-month (4-year) CD
- $2,000 in a 60-month (5-year) CD
After your 1-year CD has matured, you can reinvest your withdrawal into a 5-year CD. Repeat this process as each shorter-term CD matures, and you’ll eventually end up with a portfolio of 5-year CDs with one maturing each year. This CD ladder is an attractive method because long-term CDs typically offer higher interest rates than short-term CDs. So, you’ll be getting the benefits of the best interest rates while still maintaining flexibility (and liquidity), because you will have one CD maturing every year.
Resource: Building a Reverse CD Ladder
Are CDs a Worthwhile Investment?
CDs have multiple benefits that make them attractive for investing your money. Since CDs are offered by banks and are FDIC-insured up to at least $250,000, they are considered safe. You don’t risk losing money. Another advantage is the guaranteed interest rate. You’ll receive a fixed, predictable return on your money.
Despite these benefits, CDs have several disadvantages that can be deal breakers to some. One of the major drawbacks of CDs is the lack of liquidity. Once you deposit your money into a CD, you’ll have to pay an early withdrawal penalty to get access to your money before the end of the term length. The early withdrawal penalty can be several months’ worth of accrued interest.
Another disadvantage is that your money may not keep up with inflation during its time in the CD. Especially if you have a long-term CD, the interest rate provided may not be high enough to maintain the purchasing power of your money over time.
One instance in which a CD would be a worthwhile investment is saving for a home down payment. If you have the money already saved up and just want it to earn a little interest until you’re ready to buy the home in a few years, a CD would be a good place to park the money. In most other instances, though, you can find a more lucrative financial product to achieve your savings goals.
I’ve personally never invested in a CD. The drawbacks have always outweighed the benefits in my mind. Instead, here are two other financial products I’ve used to earn a return on my money:
High-yield online savings accounts: I have several savings accounts with Capital One 360, an online bank. Capital One 360 offers a 0.75% interest rate on its savings accounts (as of February 3, 2017) — just 0.15% less than what the online bank offers for CDs. So I get the advantage of having continuous access to my money, while still receiving a notable amount of interest.
Learn More: The Best High-Yield Online Banks
Stock market investing: I have invested money in the stock market through mutual funds with T. Rowe Price and stock portfolios with Motif Investing. In both instances, the value of my money has increased more than it ever would have had it been in a CD. Although my money in mutual funds and stock portfolios isn’t FDIC-insured and the returns aren’t guaranteed, the potential for growth is much higher than that of a CD.
If you want to save money and earn interest on it but know that you may need access to the money in the near future, a high-yield online savings account is a good option. If you know that you won’t need to touch the money in over five years, consider investing in the stock market to potentially earn a greater return than you would with a CD.
CDs are attractive because of their security and guaranteed returns. However, in most instances, you can find a better financial product that meets your needs — such as a high-yield online savings account or a stock market investment. One situation in which it makes sense to invest in a CD, though, is saving for a home down payment.
At the end of the day, it comes down to how liquid you need your money to be and your level of tolerance for risk.
Have you invested in CDs in the past? Would you do it again?
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