Is a CD right for you? Who benefits most?
A person investing $25,000 or more in a certificate of deposit (CD) is less interested in razzle dazzle — and more interested in a promised guarantee. Boring can be beneficial.
When you put money into a CD account, your job is simple: wait. Don’t watch the market. Don’t gamble on what might happen. Just wait. You know how much you will make, and you know exactly when to collect your reward.
A CD is a timed deposit with a guaranteed rate of return. That means you agree to invest your money for a certain period of time, known as a “term,” which generally ranges from one month to five years. During this time, you can’t access your money without potential penalty fees; but when the term expires, you know precisely how much you will earn.
As an example, let’s say you invest $25,000 for one year with a 1.8 percent rate. You simply leave your money alone. Then, upon maturation, you get your initial investment, plus an extra $450 just for waiting. If you change your term to two years at 1.9 percent; you get an extra $475. And if you choose a five-year term at 2.15 percent, you earn $537.50. In these examples, the investor does nothing, except wait for the CD to mature and collect the earnings. There is no risk and no hassle; just guaranteed income.
Rates depend on the size of the initial investment (usually $25,000 to $250,000) and the length of the term (generally one month to five years). Amounts larger than $250,000 can be accepted, but the FDIC only insures up to that amount. Annual percentage yield (APY) rates fluctuate and vary among lending institutions, but non-traditional, federally insured banks tend to offer significantly higher rates than big-name banks, due to reduced overhead.
Also, CDs generally offer better interest rates than savings accounts, but the trade-off is not having immediate access to your money. If you already planned to keep your cash sitting in the bank, with no transactions necessary, a CD may be a favorable option.
Who benefits most from CDs?
- A business on the verge of expansion – Perhaps you are a business owner in the enviable position of having accumulated some excess money. Maybe you plan to acquire another company in a few years when that owner retires. You need to use the sum you’ve collected, but not for at least 36 months. Why not earn while you wait? With a 2 percent rate, $100,000 would turn into $102,000 in three years. That’s like getting free office furniture and a computer.
- A person stockpiling for a down payment – Maybe you plan to build a house in a few years and you are saving for a down payment before construction begins. In addition to budgeting diligently, you could earn an added bonus. With a 2 percent rate, $50,000 would turn into $51,000 when the CD matures. That may be enough to fund a kitchen counter or appliance upgrade. The little things add up.
- Retirees-to-be – If you plan to retire in five years or less, your budget may not allow you to risk losing any part of your hard-earned savings—especially if you are depending on the interest on that money. A CD allows those preparing for retirement to earn with stability, and to be assured of a risk-free, guaranteed outcome. It may not be ideal for someone retiring in 20 years, however, since inflation may outpace CD rates, long-term.
- The inert investor – Maybe you are an infrequent stock market watcher and have no interest in playing the field. You aren’t willing to take risks, so you prefer a guaranteed return on your investment with little or no personal involvement. A CD may be a good option.
- A business requiring stability – Many businesses who depend heavily on certainty have invested in CDs. For example, community credit unions need to guarantee the security of their own clients’ transactions, so they might consider CDs to grow their overall investments under the most secure conditions.
- Those waiting for rates to rise – If interest rates are consistently low for a while, it is common to hope for the promise of something better for your investment just around the corner. In this case, putting money in a short-term CD may allow you to hold that money securely for a brief time, then re-think the investment if rates begin to rise.
Some situations are not a great match for CD investments. In general, CDs are not the best option for those who need regular access to their money or for those who can weather the highs and lows of the stock market over time.
- Penalties for early withdrawal – If you adhere to the terms of your CD, there’s no problem. If you need to terminate the agreement early, you will be charged a penalty, which may negate the interest earnings. Choose your term carefully to anticipate your liquidity needs.
- Locked interest rate – The interest rate locks in for the term of the CD. Even with confounding market fluctuations, the CD rates are not variable until the time of withdrawal or rollover. Stability and low-risk are the selling points of CDs, making potentially advantageous variability unavailable, depending on the financial climate.
Laddering is a way to take partial advantage of variable rates, especially if the rates are low at initiation. If you choose a CD ladder, you divide your investment among several smaller CDs at higher rates that mature at staggered dates. This strategy offers maximum growth and a bit more liquidity; in other words, your funds become available a little faster.
For instance, you may open one CD that matures in a year, a second CD that matures in two years, and a third CD that matures in three years. When the first CD matures, you roll that money into a new three-year CD. You do the same thing when the second CD matures. Ultimately, you end up with a three-year CD maturing every year for three years. You can also set up a five-year ladder to maximize earnings and build in some flexibility.
- Taxability – Unlike treasury notes (T-notes), the interest on CDs is not exempt from local and state taxes. Interest is taxed as regular income and not at the more favorable capital gains rate.
- Long-term inflation considerations – While it’s true that CD earnings are predictable, inflation rates are not. If you are investing early in life and do not need direct control of or access to your money for a significant period of time, most experts say it is generally advisable to invest in securities like stocks, bonds or mutual funds—which sacrifice short-term volatility for long-term gains. It is possible that inflation could outpace CD returns over decades.
The guarantee is guaranteed
In the investment world, promises are uncommon. CDs, however, are 100 percent guaranteed and FDIC-insured up to $250,000—the maximum allowed by law.
Investing in a CD through a reputable institution provides impenetrable security for your money.
There are few certainties in finances, and CDs are about as reliable as it gets.