How to Pick the Right CD (Certificate of Deposit)
What is a CD?
Banks offer common savings products called certificates of deposit, or CDs, which allow you to earn interest on your money. That means in exchange for putting your money in a bank CD, your money grows. However, withdrawing funds from a CD earlier than the pre-specified terms will cause you penalty fees. Regular savings accounts allow account-owners to withdraw funds any time they want. However, the drawback to is that savings account-holders will miss out on being able to earn significant interest on their deposits.
So where do you start? There are so many places to grow your money, it can be overwhelming to figure out the differences, and which CD will suit your goals and lifestyle the most. Picking the CD that meets your needs will require careful consideration of the features and drawbacks associated with each type of CD. To make your choice easier, we have done the research and will simplify the types of CDs you can choose from, and what they offer.
Traditional CDs are CDs with a fixed interest rate for a fixed term, as opposed to a variable-rate CD (in which we discuss below). Traditional means that the CD will be purchased for a fixed term, such as one year, five years, etc., and the amount of interest accrued is also a fixed percentage.
Traditional CDs are also referred to as time deposits because of the length of time involved. The rule of thumb is typically the longer the CD, the better the interest rates. A traditional CD is attractive because of its stability. However, as we mentioned earlier there are generally penalties accrued for withdrawing early from a traditional CD account, which can be avoided if you choose a different CD type (which we discuss below).
Bump-up CDs (Variable-rate)
Bump-up CDs allow account-holders to capitalize on a rising rate environment. For example, if you were to purchase a two-year CD at a given rate, and half a year into the term your bank is offering an additional quarter-point on two-year CDs, you would have the option of telling the bank that you want that higher rate for the remainder of your CD term.
Institutions that offer bump-up CDs usually cap the bump-up at one per term. However, the value of purchasing a bump-up CD is somewhat immeasurable. as this type of CD usually comes with a lower initial rate, as opposed to a traditional two-year CD. Interest rates may take a while to rise, and the longer they take, the higher the increase has to be in order to make up for the lower-rate portion of your term.
Be realistic about the interest rate climate and weigh your options carefully before buying a bump-up CD.
Liquid CDs are ideal for conservative investors looking for more flexibility. Consumers with this type of CD are able to withdraw money early without incurring a penalty fee. However, part of the tradeoff is that the account-owner may have to maintain a minimum balance in their account.
The interest rate on a liquid CD is usually higher than the bank's money market rate, but lower than the rate of a traditional CD of the same length and minimum. One thing to keep in mind about liquid CDs are the limitations for how soon the consumer can withdraw funds after an account is created. Federal law mandates that the funds must stay in the account for seven days before it can be withdrawn, penalty-free.
However, the bank also gets a hand in creating limitations, as they can set the first penalty-free withdrawal for any period after that.
Finally, there is a set number of withdrawals allowed, so consider whether the convenience of liquidity makes it worth it to sacrifice a higher return on your interest, which would come with similar CD terms without the liquidity feature.
IRA CDs are somewhat misleading. There is no actual specifically designated CD that favors the soon-to-be retired. An IRA CD is merely a regular CD held within a tax-advantaged individual retirement account, hence the name IRA.
However, banks often market CDs as being IRA CDs, leading consumers to believe that there is some type of distinction. While a bank markets this type as being "IRA-friendly" and may come with attractive terms, there are other CDs that are just as good.
In preparing for retirement, buying a CD is an extremely safe investment to make, as the government backs CD terms up to $250,000, so even if the bank has no more funds available, your return is guaranteed. Also, IRA rules are flexible in regard to IRA investments, so the funds inside an IRA account can be used to buy nearly any type of investment, and any type of CD.
Callable CDs are tricky to explain. Callable CDs are attractive to consumers because they offer bigger yields than regular CDs. However, they're named "callable" because of the feature included for the issuer of the CD to be able to call the CD back, thus taking a CD from a customer before the full amount matures.
The only time banks typically do this is when interest rates have fallen and they have an opportunity to sell CDs that offer much lower interest rates. The bank would clearly prefer to borrow money and pay less interest to a new customer, as opposed to allowing a customer, who purchased a CD when rates were attractive, to fully cash in.
Therefore, after a certain period of time, the issuer can call back a consumer's CD, giving them the amount invested as well as interest accrued, but halting the terms of their CD so that whatever the amount of time their CD was purchased for is slashed and never reaches fruition.
Jumbo CDs are CDs with a minimum denomination of $100,000. The incentive to buy a jumbo CD is the higher interest rates that are offered, as opposed to a traditional CD. However, whether the rate difference is significant enough to merit dropping in $100,000 is arguable.
When bank loan demand is down, deposit rates are less appealing because the bank needs for a steady supply of cash isn't high. However, when loan demand is high, banks typically raise interest rates on CDs as a way of getting access to more funds. If you have a lot of savings and are considering buying a jumbo CD, it's worth it to check the rates between a traditional 1-year and jumbo 1-year CD (or whatever term you're considering) to see whether the interest rate is high enough to be worth tying up your money.
Typically, jumbo CDs are bought and sold by large institutional investors such as banks.
CD ladders help wary consumers take advantage of the higher interest rates of a 3-5 year CD. Since consumers are typically wary of tying up their money for a lengthy period of time, building a CD ladder is a more appealing way of capitalizing on the earnings accumulated through 3-5 years.
The process of building a CD ladder is less complex than one might think -- simply invest proportionally in a number of CD terms, and as each shorter CD matures, take the earnings and reinvest in a 5-year CD, and so on and so forth until a 5-year CD is maturing each year.
For example, take a consumer with $20,000 in savings:
- Invest $1,000 in a 1-year, 2-year, 3-year, 4-year, and 5-year CD.
- In a year, when your 1-year CD matures, withdraw the $1,000 + earned interest and deposit the amount in a 5-year CD.
- The following year, do the same on the next CD that's matured, and deposit that amount in a 5-year CD as well.
- Repeat this process until a 5-year CD is maturing each year.
In short, it all depends on the length of time you want your money tied up for, how much interest you're looking to earn, whether you have an aversion to risk-taking, and how strategic you want to get.
Certificates of deposits are considered one of the safest investments out there, since they are FIDC insured, so for beginning investors, purchasing a CD may be a great way to start.