What Is a CD and What’s the Best Way to Invest with Them?
Find high-yield CDs and learn how “laddering” can boost returns.
In last week’s article (8 Tips to Invest Without Too Much Risk) I gave you tips about how to invest money in the financial markets without taking too much risk. This week I’ll tell you about CDs, or certificates of deposit, and how you can use them to keep your money completely safe. You’ll get an overview of the different types of CDs and learn the best places to find high-yield CDs. I’ll also reveal a special technique called “laddering” that’s a smart way to maximize income from CDs.
What is a CD (Certificate of Deposit)?
A CD is a financial product that’s offered by banks and credit unions. The minimum amount that’s required to open a CD is generally $500. As long as you buy one from a bank with FDIC insurance or from a credit union with NCUA (National Credit Union Administration) insurance, it’s federally insured up to a certain amount, just like other types of bank accounts. (For more on what those limits are, see Chapter 3 of my book Money Girl’s Smart Moves to Grow Rich.)
A CD is different from a savings or a money market account because you give up access to your money for a period of time, which is called the term. In exchange for agreeing not to touch your money during a CD’s term, you typically get more interest than with other types of deposit accounts. A CD gives you a guaranteed return—albeit a low one right now—no matter what happens to the economy or the financial markets.
Can You Withdraw Money from a CD?
Typical CD terms range from three months to five years with the longer terms generally yielding the highest interest rates. Though it can bereally tempting to buy a CD with the longest term, you have to be certain that you won’t need to withdraw the money before the maturity date because that can result in a high penalty.When the term is over you get back your principal (that’s your original deposit) plus the accumulated interest.
What are 8 Different Types of CDs?
What I’ve just described—a product with a fixed term and interest rate—is called a traditional CD. That’s the most common type, but there are other kinds. Here are 8 different types of CDs to be aware of:
Variable CDs pay an interest rate that’s based on an index such as the Treasury bill rate or the prime rate.
Zero-coupon CDs pay interest only at the end of the term and don’t allow the option to withdraw interest.
Add-on CDs allow you to make additional deposits to a fixed- or variable-rate CD.
Callable CDs give the bank the right to “call” or buy back a CD after an initial period and before the end of the term.
Liquid or No-Penalty CDs allow you to withdraw a portion of your money without paying a penalty.
Bump-up CDs give you a fixed interest rate with the option to increase the rate one time during the term of the CD to take advantage of rising interest rates.
Step-up or Step-down CDs give you a fixed interest rate for a set period of time and then automatically increase or decreaseto a predetermined rate.
Jumbo CDs require a deposit of at least $100,000 and typically offer a higher rate of interest.
Understand APY vs. APR
Speaking of interest, there are two main ways that interest is expressed for CDs: APY and APR. APY stands for annual percentage yield and it’s the rate you’d receive if all the interest you earn gets added back to your balance, or is compounded. In other words, APY is the rate you’ll get if you never withdraw interest from a CD.
APR, on the other hand, stands for annual percentage rate. It’s the rate of interest you’d earn without taking into account the effects of compounding in that year. It’s the rate you’d receive if you withdrew every penny of interest and didn’t allow it to compound. When you see a CD rate that doesn’t specifically say it’s the APY, you should assume it’s the APR.
How to Find the Highest CD Rates
As I mentioned, the longer you’re willing to commit money to a CD, the more interest you’ll typically earn. For example, right now Ally Bank is offering a 5-year CD that pays 2.39% APY and a 1-year CD that pays 1.29% APY.So if you put $10,000 in the 1-year CD, and didn’t withdraw any interest, you’d make $129 at the end of the term. To calculate your return on CDs with terms longer than one year it’s really helpful to use a CD calculator.
Let’s say you want to know how much you’d earn if you put $10,000 in Ally’s 5-year CD. If you use the CD calculator at dinkytown.com, it asks for your initial deposit, the CD term in months, the interest rate (which is the APR, not the APY), and the compounding frequency. Ally’s site tells you that the rate is 2.36% and that interest is compounded daily. Entering this information shows that you’d have $11,252 at the end of the 5-year term. That means you’d make $1,252, assuming that you didn’t withdraw any interest.
Online banks have some of the highest CD rates, so check out sites that compare national offers like bankrate.com, bankaholic.com, and money-rates.com. Also be sure to check rates at your local community banks and credit unions because they can offer very competitive CDs when they’re trying to attract more deposits.
What is CD Laddering?
Before you buy a CD consider using a common strategy called laddering to help maximize your potential earnings. Laddering simply means that you own CDs with different maturity dates and annual yields. Each rung on a CD ladder represents a different CD that has a progressively longer term.
Here’s an example of why it’s a good idea to ladder CDs: Imagine that you put $100,000 in a traditional 5-year CD that pays 2.5%. Now, think how bummed you’d be if the interest rate for a 5-year CD went up to 3.5% the following year. You’d miss out on earning more interest because you locked up your money at 2.5% for 5 years and can’t withdraw it without paying a penalty.
With laddering you might choose to buy five CDs with your $100,000, instead of just one. For instance, you could put $20,000 in a 1-year CD, $20,000 in a 2-year CD, $20,000 in a 3-year CD, and so on, up to a 5-year CD. After one year when the first CD reaches maturity, you can use all or a portion of the money to purchase another 5-year CD. So, as your shortest CD matures you use it to buy a longer term CD that presumably has a higher interest rate.
This laddering technique protects you against missing out on higher returns if interest rates rise. Laddering allows you to earn more money and gives you greater flexibility because as each CD matures you have the option to renew it at the current rate or to use your money for something completely different. Use a CD ladder calculator to see how you could benefit from using this strategy.
When Should You Buy a CD?
Now that you know more about CDs, you might be wondering if you should buy one. A short-term CD might be a good option for funds that you plan to spend after the maturity date on something like a house down payment or a vacation, even if it’s just a small amount of money.But be sure to research interest rates on high-yield savings and money market accounts because they may pay a return that’s very similar to or more than a short-term CD without requiring you to sacrifice liquidity, or quick access to your money.
The most common reason to buy a CD is when you have a relatively large amount of cash that you want to keep completely safe while earning a little more interest than you could with a savings or money market account. This might be the case if you’re retired, are approaching retirement, or are simply too risk averse to invest any amount of money in the financial markets.
Balancing risk and reward is the ongoing struggle that all savers and investors face, especially right now with interest rates at record lows. CDs don’t offer much return on your money but they’re a sure thing with virtually zero risk.
Money Girl’s Smart Moves to Grow Rich
If you like the tips you get here I think you’ll like my new book, Money Girl’s Smart Moves to Grow Rich. It tells you what you really need to know about money without bogging you down with what you don’t. The paperback is available at Amazon.com or your favorite book store and as an e-book for your Kindle, Nook, iPad, computer, or smart phone. Visit SmartMovesToGrowRich.com to download two free chapters and to get a complimentary video, “How To Organize Your Financial Records.”
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