How to Use CDs to Save for a Home Down Payment
Buying a house is one of the biggest -- if not the biggest -- milestones in life. Unless you pay for it in cash, you’ll need to come up with a sizable down payment before you can call that home you’ve been eyeing up your own.
Generally, you’re expected to produce a down payment anywhere from 5 to 20 percent of the home’s value in order to qualify for a mortgage. The higher, the better, since the bigger your down payment, the lower your monthly mortgage payments.
Expenses, bills, and life, in general, give few opportunities to aggressively save for a down payment. But you don’t need to put off homeownership as an unreachable goal or unrealistic pipe dream.
Here’s how investing in a CD (or multiple CDs) can send you on the fast track to a home down payment.
Why CDs Make Sense for a Home Down Payment
“CD” stands for certificate of deposit. It’s a type of savings account that requires you to lock your money away for a predetermined period of time, anywhere from 6 months to 5 years for most accounts.
This might initially seem like an inconvenience if you’re used to a savings account with immediate liquidity to withdraw your funds when you like. But CDs are equipped with some benefits you won’t find anywhere else:
1. Their interest rates are unsurpassed.
In exchange for keeping your funds on deposit, a CD builds interest at a higher APY (annual percentage yield) than most other savings accounts. The money compounds interest for the duration of your deposit until it reaches maturity.
How do CD interest rates stack up against the conventional savings account? They tower over them, actually. At online banks, CD rates are among the highest that you'll find, especially compared to CD rates from national banks.
2. Your funds are safe and secure.
CDs are designed to actively help you save money without the back and forth of depositing and withdrawing from a common savings account. They’re locked away and can’t be touched without paying a penalty fee -- one incentive to keep depositors on point and saving towards their goals. You could keep a stack of cash at home or simply lump the money into your daily savings account, but in the first case, you won’t earn interest, and in the second, you may be tempted to withdraw. CDs are safer than both options, plus, the FDIC insures them up to $250,000. The deposit lock in tandem with higher interest rates makes a CD an impressive savings outlet for the short-to-medium term until your account reaches maturity.
Once that happens, you’re free to withdraw your money, which, depending on your interest rate, has turned into a nice investment to use towards a big purchase -- namely, a mortgage down payment.
How to Use CDs Wisely
CDs are a simple way to save: just deposit, sit back, watch the interest accrue and withdraw. But there are strategies to keep in mind to maximize your deposit:
CDs are like a ladder to greater wealth, but a CD ladder is literally a ladder of several CD accounts, of different lengths, set up to mature at different times with different interest rates.
Now, if you had $10,000 you wanted to deposit, you can’t go wrong with putting it in one CD, with one interest rate, locked in for one period. But CD laddering, on the other hand, gives you more flexibility and savings potential.
Say you split that same $10,000 across five different CDs: $2,000 each, for five terms, at 12, 18, 24, 36 and 48 months. While you’re waiting for the 4-year CD to mature fully, your shorter CDs will reach their end quicker, giving you the opportunity to have access to your interest-fortified savings.
So, when your 12-month CD matures, you can reinvest it into another CD with a better interest rate, and when your original 12-month CD matures, repeat the same, and so on for your other CDs. You can even reinvest them into shorter CDs as you go, timing them all to mature at the time of your longest CD account, to withdraw all your funds at roughly the same amount of time to apply for a mortgage.
That’s just one example of how investing in a ladder of CDs, from smaller to bigger, and timing them just right, can work to your advantage. You emerge with more savings than anticipated and more money towards an initial home down payment.
Avoid specialty CDs
We’re not here to discourage anyone from investing in something with clear savings advantages, but in this case, refrain from depositing money in “specialty” CDs. In this case, avoid CDs advertised with no penalties for early withdrawals, or those that offer deposit amount or interest rate bump-ups. At first glance, these are great CDs for general savings, because you can withdraw without paying fees, and deposit more money as you go with interest rate increases -- rarities in the CD world.
But these CDs also come with lower interest rates that can counteract the initial benefits -- the last thing you’d want when saving for a mortgage, on a budget, and on a timeline.
Remember your auto-renewal
Auto-renewal is great because you can set it and forget it; deposit your CD funds, wait until your term expires, and your CD is automatically restarted at the same term, but with the current interest rate.
But is this what you really want? Many people who don’t want to renew their CDs assume that their money will be accessible at the term’s end, only to find out that their CD has started itself all over again, and their dividends aren’t available without penalty.
Unless your intent -- perhaps part of your CD laddering strategy -- is to auto-renew your CDs, remind yourself if your accounts have this option, and instruct your bank or CD provider otherwise.
Which CD Do You Pick to Save for a New Home?
CDs are the type of savings account that works so simply, yet your choices are complex as ever. Ask yourself some important questions when looking for the right CD(s), since the interest you earn can play a big role in building a sizable home down payment.
Important factors include:
- Interest rate
- Maturity term
- Early withdrawal penalties
Interest rates for faster growth
What kind of interest rate do you want? The point of a CD is to earn you a higher interest rate than a standard deposit account -- much higher. If the CDs you’re finding offer minimal interest (or, in some cases, less interest than a savings account), keep looking.
A good CD offering should come with rates that are at least a full percentage point, sometimes double that, to help multiply your money quicker and more robustly than any other product.
When will you need the money
What term do you want? Or, in other words, how long do you want to save for? As per account protocol, the longer the CD term, the higher the interest rate. So, a 60-month CD will offer a higher interest rate than its 6-month counterpart. The longer your money is locked away, the more discipline you’ll need to keep it there without withdrawing, and as a reward, a stronger APY.
But beware of CDs with terms that are too long. If you’re looking towards making a house down payment in one to two years, and all your money’s been put away into three CDs with terms of 36 months or more, that’s a long time to wait and put your plans of homeownership on hold.
Our advice? Start small if you’re new to CDs. Pick accounts with terms no longer than 12 months, 18 at the most. That way, you can get a feel if CD investing is right for you, and from there, graduate up to longer terms, incorporating a laddering strategy as you go.
What happens when you need the money early
Beware of early withdrawals. Just what are those penalty fees we’ve been mentioning here and there? Simply stated, if you remove money from a CD before the term matures, you’ll get hit with a surcharge -- usually several months’ worth of earned interest. That’s a big hit to your finances, so keep in mind that the money in your CD needs to stay there until its term is complete.
Why do banks charge early withdrawal penalties? Banks offer high interest rates on CDs, so if a depositor makes an early withdrawal, the bank needs to recoup its losses; and by taking back some of the interest you’ve earned, you’ve done yourself a disservice and failed to let your CD do its work.
First, find out what you can afford to deposit in a CD. Some people make the mistake of depositing every cent to their name in a CD, and since the money is locked away, they have no liquid funds at hand -- so, they’ll make frequent withdrawals against their benefit.
An alternative? Deposit as much as you can afford to tuck away in a CD, and put the rest in an online savings account. Dividing your money is the most profitable -- and smartest -- way to go.
A good piece of financial wisdom is to remember that to save money, you need money. Make sure you reach a target dollar amount that you can deposit into a CD or CDs, and watch the money grow from there.
A CD should complement your savings for a home down payment. Look for other ways to invest in addition to a CD, and the money you save from different revenue streams, combined, can make for a nice chunk of money towards that mortgage.
Look at your time invested in CDs as a relationship that’s meant to end. It begins, it matures, it comes to pass -- but in the end, you and your finances are richer for the experience, and your path to affording a home, well within reach. More: Best CDs of the Year