Whether you invest or not, you probably keep some of your savings in a traditional bank account. This money loses value every year, either in form of inflation or opportunity cost. But what if there were a way to earn interest without adding risk?
That’s the purpose of a certificate of deposit (CD). Keep reading to find out if it fits your financial strategy.
- How Certificates Of Deposit Earn You Money
- 3 Reasons to Use Certificates of Deposit
- 3 Reasons to Avoid Certificates of Deposit
- Variations to the Traditional Certificate of Deposit
- Certificates of Deposit and Bonds
- Should CDs Be In Your Investment Portfolio?
How Certificates Of Deposit Earn You Money
Simply explained, the certificate of deposit is an alternative to your savings bank account. They offer better interest rates, but you cannot access the initial amount until the agreement expires (from 6 months to 5 years).
By definition, it’s a low-risk investment product you can get from banks and credit unions. You deposit money for a fixed period and collect annual interest until maturity. Longer terms imply higher rates, but because of liquidity, most institutions offer up to 5-year CDs (being 3-year CDs the most efficient and popular).
Here’s the average annual percentage yield (APY) you can expect from a traditional certificate of deposit:
- 0.3 – 0.5% for 6-month CDs
- 0.6 – 0.7% for 1-year CDs
- 0.7 – 0.85% for 3-year CDs
- 0.9 – 1.1% for 5-year CDs (sometimes up to 2%)
Unlike savings accounts, certificates of deposit have a minimum investment amount. It usually starts at $1,000 and goes up to $5,000 for long-term CDs.
You can also find banks offering 1-month certificates of deposit at 0.1% – 0.2% APY. The problem is, you may not receive APY distributions until the end of the year or quarter. Monthly distributions may only apply to long-term clients.
3 Reasons to Use Certificates of Deposit
The following benefits make CDs useful for almost any situation. Whether you’re looking for a better savings account or investing long-term, you can earn more interest with minimal risk.
#1 Almost as Safe as Your Savings Account
The bank guarantees to return the principal at maturity. In the rare case they run out of business, they pay off these first, before their other investment products. So it’s safe to say you won’t lose your money.
The second worst scenario is cash flow issues. The bank/credit union may not have the money on distribution, so they add it up for the next date. Or they offer all the owed interest as a lump sum on maturity.
But most importantly, certificates of deposit are safer from inflation. It’s not enough to beat the average 2-3% loss, but it’s one of the best options available right now. The best CD rates can reach 2% APY for long-term plans.
As for traditional plans, savings accounts rarely yield over 0.10% per year. The closest competitor is a high-yield savings account, with variable rates reaching 1% APY (more about this later).
#2 You Know Exactly When You Get Paid
You know you’ll get your money back when the risk is so low. And unlike trading securities, certificates of deposit don’t rely on the economy as much. Instead, they work like loans and bonds.
And while lending is low risk in general, the risk of CDs is even lower. The FDIC insures up to $250,000 of your CD if the institution can’t pay it back. For inflation-protected CDs (CDIPs), this insurance applies up to $100,000.
If you want to get paid more often, you can create what’s known as CD laddering. For example, you can invest $10,000 by creating five CDs, being each one longer by one year. $2,000 for a 1-year CD, 2-year CD, and so on.
Every year you collect your principal, you can choose whether to continue the ladder or stop investing. If you keep doing it, you’ll eventually be collecting 5-year CD interest every year. Which solves the cash flow issue.
Another strategy is to create multiple short-term CDs. If the average 1-year CD yields 0.6% and the 6-month CD offers 0.4%, you can just reinvest in this one twice. After 12 months, you get 0.8% APY compared to 0.6% (plus compound interest from the first 6 months).
#3 Many Variations to Fit Your Needs
Maybe CDs don’t fit your portfolio because of their limitations. You like the rates but don’t want to lock your funds for so long. Or you’d rather get the most convenient rate rather than fixed interest.
It turns out there are CDs for all these purposes:
- Inflation protected CDs
- Special CDs for retirement plans
- CDs with no withdrawal limitations
- CDs you can trade on secondary markets
- CDs that allow reinvesting and consider compound interest
With this flexibility, it doesn’t make much sense to look at the pros and cons of certificates of deposit. You have all these options to find the right CD. Regardless of the pros and cons, this diversity is a plus.
3 Reasons to Avoid Certificates of Deposit
The benefits of CDs show what makes them great tools for the right investor. For someone looking for a higher risk-reward, these benefits may not mean much. Especially when considering the limitations:
#1 Penalty Fees for Early Withdrawal
Canceling a CD is NOT worth it. Unless you’ve been collecting some interest already, chances are you’ll be below your initial amount. There’s a minimum fee, and the penalty increases with the maturity date:
- For 3-12 months of maturity, 3+ months worth of interest
- For 12-24 months of maturity, 3 – 6 months worth of interest
- For 24+ months of maturity, 6 – 12 months worth of interest
Penalties cost you from 20% to 33% of the interest you could have earned, plus $20-$50 as the minimum fee. If you’re investing the $1,000 minimum amount, this fee represents a loss of 2%-5%.
Before you deposit, you must be sure that you won’t need that money for those years. Grow your emergency fund first to prepare for the uncertain economy.
#2 Funds Locked for Years
Unlike your savings account, your CD balance is frozen until maturity. If you need the money back for emergency reasons, you’ll need to pay the penalty fee. Since that defeats the purpose of investing, there’s no choice but to wait.
Sure, some certificates of deposit don’t have penalties. Others can be traded. But when looking for the highest rates, those CDs won’t have this feature.
The only way banks can offer high rates is by putting your money to work. High-yield CDs wouldn’t work if you had constant access to those funds. The same applies with interest: distributing APY every quarter (rather than every month) can lead to higher rates.
#3 Returns Aren’t That Great
While there are many CD variations to fit your strategy, they all offer similar results. Banks set the rules, and they want a profitable investment just like you. So while there may be a dozen options, it’s the same offer.
- No-penalty CDs and brokered CDs offer more liquidity for lower interest rates
- Rate-adjustable CDs may offer 1.5% APY or 0.1%
- Inflation rates may go higher than you expected
Expected returns are rarely as advertised. They look more like this:
Don’t expect great returns from no-risk investments. 1% is no match to the 2-5% coupon rate of a bond, or the 7% APR of a personal loan. You have to choose whether you want to deal with the risk of inflation or the risk of investing.
Variations to the Traditional Certificate of Deposit
Despite the cons, certificates of deposit are one of the safest investment products. Because of this low risk, banks can offer more flexible plans for their clients. And while there are a dozen different types, you can spot four simple distinctions:
#1 No-Penalty CDs
No-penalty CDs allow you to withdraw your funds whenever you need them. It’s free up to 1-6 withdrawals per month, which is reasonable for a savings account. And because of this feature, the rates may be lower than on traditional CDs.
But because of this feature, there’s no risk in taking 5-year CDs for higher interest. Investors also call them liquid certificates of deposit.
Are they better than penalty CDs? You have to compare to find out. If the penalty is small, it may still yield more than a penalty-free CD.
#2 Adjustable CDs
CDs are generally fixed both on the principal and interest rate. It’s a reason these investments are so safe. At the same time, this feature creates two problems:
- You don’t get an updated interest rate. You might be stuck with, say, 0.5% APY, when the new average is 0.8%
- You cannot reinvest the money on your CD. You need to create a new one, with whatever rates apply at that time (possibly lower)
Adjustable CDs introduce both variables. You can reinvest and grow your balance with compound interest. And sometimes, you can choose when to update the rates, whenever it’s convenient for you.
In investor terms, there’s no such thing as “adjustable CDs”. It’s a category we use for all CDs that include this feature:
- Bump-Up CDs: Suppose your bank raises its APY months after you invest in your CD. You can ask them to update to the higher rate for the rest of the term (typically once per CD). In the case the rates are lower, they won’t update your APY unless you request it.
- Step-Up CDs: While bump-up CDs can change once, step-up CDs update on every term automatically. If you invest during a downtrend, your APY might be over 1% for short-term CDs. Otherwise, the overall rate may be lower than on traditional plans.
- Add-On CDs: Let’s say you bumped up your CD to a higher rate. Because you’re making more money, you want to invest more (which is not possible on conventional plans). Add-on CDs allow you to reinvest up to a certain amount/frequency.
You can see how CD rates spike from time to time. Based on historical data, the ideal CD could be bumped up, penalty-free. And if the rate is too low, traditional CDs do well too.
#3 Zero-Coupon CDs
Zero-coupon CDs pay no interest until maturity. And because there’s no liquidity, these rates might be as high as 3%. It makes sense only if you don’t plan to use the money (e.g., retirement).
Mind that the interest also contributes to your tax bracket every year. The IRS requires it whether you can access the funds or not, so make sure you build your emergency fund first.
Note: Even though you don’t receive interest, this rate could still be adjustable. If you get a zero-coupon bumped-up CD, you could get even higher rates on maturity. Or maybe there’s a zero-coupon penalty-free CD, so you can withdraw early along with the interest accrued.
#4 Brokered CDs
Similar to penalty-free CDs, you can withdraw your funds from a brokered CD. It’s a product kept in your broker account, which you can buy or sell to other investors. It allows you to collect interest from CDs while selling them when convenient.
This feature, however, affects profitability. Liquid CDs offer lower rates, and every time you trade one, you pay fees to the broker too. Not different from a withdrawal penalty.
Brokers also offer limited investment choices. Chances are they only offer traditional certificates of deposit.
Certificates of Deposit and Bonds
A CD pays you interest while locking your funds until maturity. A bond pays you a coupon rate (interest) while keeping the principal until maturity. What’s the difference?
While the definition is the same, the purpose is not:
Short-Term VS Long-Term
- When looking at the offers, the longest CD maturity you’ll find is 5-10 years. As for bonds, these can earn you interest for 30+ years
- A certificate of deposit pays you every month/quarter. A bond pays you every 6 months/year
- When investing in CDs, your ROI relies only on the APY. If you buy bonds, however, you can also sell them for profit.
People use CDs the same way they could earn interest from short-term lending. Except that certificates of deposit offer lower risk. As for long-term investing/retirement planning, investors choose bonds.
Government bonds also offer tax benefits that CDs don’t.
But why are certificates of deposit short-term?
Anything can happen to the market when measuring 1-5 years. Companies may go out of business and default on your bond, even though long-term projections are good. As for CDs, the FDIC insures up to $250,000.
Illiquid VS Liquid
While you can withdraw early from a CD, you get the best rates by leaving your funds untouched. Liquidity can be a problem when you could use that money on another opportunity. Bonds don’t have this limitation.
You can sell your security anytime and keep the interest accrued. Bonds can also benefit from compound interest, inflation protection, and adjustable rates.
When trading bonds, you sell relative to the current price. You can sell for profit when bond prices are high, and if prices are low, you can wait and collect more interest. However, lower prices increase the risk of loan defaulting.
CDs limit how much you can adapt your strategy, which is why they’re short-term.
No-Risk VS Low Risk
The FDIC insures the principal your certificate of deposit. With bonds, the company compromises to pay bondholders first. In case of cash-flow issues, they repay the missed interest as late as the maturity date.
Both securities offer minimum risk when you choose AAA+ bonds. That’s the highest reliability rated by financial agencies (e.g., Standard & Poor). But if an economic disaster were to happen, CDs are the most protected.
Should CDs Be In Your Investment Portfolio?
Certificates of deposit make good choices for saving money. If you plan to buy a house in a few years, you can keep your funds in a high-yield CD rather than a 0.04% APY savings account. Or if you’re planning for retirement, you could bundle long-term CDs with some bonds.
If you want easy access to your funds, learn about high-yield savings accounts (~0.50% APY, minimum deposit below $100).
If you have no idea of what to do with your savings, it might be better to lock those funds until you’re more clear of your strategy. After all, we tend to waste money when it has no purpose. Someone may try to sell you something you don’t need, or worse, get you in an investment scam.
CDs are one way to grow your portfolio. Before weighing the pros and cons, set accurate financial goals.