When Are CDs A Good Investment?

Key Takeaways

  • Bank CDs offer a fixed interest rate for a stated period of time, without the market risk of losing the principal.
  • While yields have been low for some time, they have been increasing as the Federal Reserve raises interest rates.
  • Using a CD ladder is a solution to overcoming many of the drawbacks of investing in CDs.

Are certificates of deposit a good investment? The answer to that 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 you can build a CD ladder to overcome some of the drawbacks of CDs. Here is everything you need to know if you are thinking of investing in certificates of deposit.

What are Certificates of Deposit?

A certificate of deposit is a type of savings product that typically 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 set period. The most common CD terms are six months, one year, two years, and five years. CDs with longer terms usually have higher interest rates than shorter-term CDs. The interest rate on a CD is fixed, which means it will not change for the duration of the CD. That’s different from a savings account, where the interest rate can go up or down over time. The interest the CD earns builds up in the account, and when it matures, you get back your principal plus the interest.

Current rates for CDs

The CDs’ yields have risen 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 as high as 3.56% for a six-month CD and 3.50% for a 5-year CD.

It is important to know that when the Fed raises interest rates, it takes time for the higher rates to trickle through to CDs and other savings products. Most times, when rates rise, the interest rate on debt products, like auto loans, mortgages, and credit cards, rises immediately. Then in a few days to a couple of 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 to banks, whereas interest from loans is income.

Increasing rates on loans immediately and slowly increasing rates on savings deposits gives banks a larger profit margin. Rates for savings products do increase in time because in order to issue new loans, banks need to take in more deposits. A higher rate on savings encourages people to save more.

So if you hear the Fed recently raised rates, you don’t need to rush out and buy a CD as it won’t have an updated rate for a few days.

Reasons to invest in CDs

There are multiple reasons to invest in CDs. CDs usually pay a higher interest rate than savings accounts, so if you want to earn more money on your emergency savings, CDs are an option. Similarly, if you are on a fixed income, as many retirees are, you may want to put a portion of your savings into CDs. Not only do you earn interest, but your principal is safe as it will never go down in value. It is insured by the FDIC. If you were to invest in bonds, there is a risk that the value of the bonds could drop.

Another benefit is you know your return and can plan accordingly. Before you invest in a CD, you know the interest you will earn, and you know the time until you earn that money. This helps with planning purposes. If you need to earn a specific amount of interest to help cover living expenses, then you can figure out how much you need to invest, using the interest rate.

With CDs, there are no fees at all. You can open a CD in-person or online in minutes and pay no fees. When you invest in bonds, there are typically fees you have to pay. These could be trading fees to the broker, or to the mutual fund or exchange-traded fund in the form of management fees.

Finally, CDs give you the ability to roll over your investment. Most banks set up automatic renewal, which means when the CD matures, you have a stated 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 back into the same term CD. This makes investing in this security completely hands-off.

Drawbacks to CDs

Of course, there are downsides to CDs as well. The biggest is the lock-up period. When you purchase a CD, your money is locked up for the entire term. If you need the money, you can redeem the CD early. However, you will pay a penalty, usually a few months’ worth of interest. Some banks offer special CDs called No Penalty CDs that allow you to close the CD before the term is up without penalty.

Another issue is that CDs don’t always pay a great interest rate depending on the economic environment. From 2011 through 2019, you were lucky if you earned 1% on a 5-year CD. While this rate is higher than most savings accounts, it wasn’t enough for most people interested in this product.

Speaking of interest rates, there is a risk when buying CDs in inflationary environment. If interest rates rise and you purchase a 5-year CD, you lock in the interest rate for five years. So if you buy a CD with a 2% interest rate, and rates spike to 5%, you are stuck earning 2%. Of course, you can close out the CD, pay the penalty, and reinvest into a higher-yielding CD. As a response to this issue, many banks offer what is called a raise your rate CD. This allows you to reset the interest rate to a higher rate once during the term if rates rise.

Bonds tend to offer a better return if you want to earn more on your money. If you invest in government-backed securities, like Treasuries, 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 an issue if you invest in bond funds. If you purchase individual bonds, this is not an issue unless you need to sell before maturity.

Finally, depending on the economy, the interest you earn might not keep up with inflation. This was the issue from 2011 through 2019. While inflation was tame, ranging between 2-3% annually, CDs paid 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 invested in bonds or dividend-paying stocks, hoping to earn a steady stream of income. The problem here was many were taking on more risk than they should have to earn a higher rate.

Building a CD Ladder

To overcome some of the drawbacks of CDs, many people invest in CDs using a CD ladder. This means buying CDs of varying maturity dates, allowing 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 into the following:

  • A six-month CD paying 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 matures, you purchase a new 5-year CD. When the 18-month CD matures, you buy another 5-year CD. This allows you to continually earn the most interest and still be able to access some of the money if need be, since a portion will be maturing at regular intervals. If when the six-month CD matures you need the cash to pay bills, you can do this without having to take money out of another CD and forfeiting some of the interest.

If you put the entire $10,000 into a 5-year CD and need some cash, you cannot redeem a portion of the CD. You need to redeem all of it, then pay the interest penalty and invest what is left over 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 shortest term CD available.

How to earn higher rates on CDs

If your bank isn’t paying competitive rates for CDs, you can look online, as online banks offer higher yields. But going through your broker is where you can earn higher yields. Many brokers offer brokered CDs, which often pay higher rates than buying directly from banks. As an added bonus, there is no penalty for early withdrawal. This is because when you purchase CDs from a broker, you do so on the secondary market.

Instead of buying from a bank, you are buying from another investor or institution. If you need to sell, you are not closing out the CD. Instead, you are selling to another investor. While there is no penalty for early termination, most brokers charge a trading fee, so this needs to be considered.

Bottom Line

Certificates of deposit can be an excellent way for investors to earn a return while keeping their investment safe. The downside is that sometimes the interest earned does not keep up with the inflation rate, causing you to lose purchasing power. But when this is not the case, strategically using CDs in your portfolio can provide income while also allowing you liquidity should you need the money.

Whether or not you decide to move forward with CDs, a balanced portfolio should include a range of investments, including securities. Q.ai takes the guesswork out of investing.

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