You’ve done everything the financial experts recommend -- saving three to six months in emergency funds, regularly adding to your 401(k) and IRA, paying off your debt and putting away a percentage of your salary. Congratulations! And now you find you have quite a bit of money on hand just sitting in a savings account. What should you do with the extra funds? You should put them in a certificate of deposit (CD).
A CD is a low-risk bank deposit account that feature fixed interest rates which increase with the term of the CD. If you are looking for dependable return on your money, but don’t need to tap into your money for a length of time, a CD may be a good savings option. When to open a CD is a pretty straightforward process.
Here are three indications of when to open a CD:
1. You have a specific savings goal in mind
Just like with any investment product, it’s important to determine if a CD is suitable for your particular needs. A CD can be a great vehicle for funding short-term needs, such as a down payment on a house or purchasing a new car. CDs can also be used to build funds for longer-term goals like retirement or college tuition.
Before you lock your money into a CD for any period of time, you’ll want to consider the fees and penalties associated with liquidating the CD prior to the maturity date. “Life throws you curveballs so it is helpful to understand the worst case scenario,” notes wealth advisor Taylor Schulte, CFP. On this note, it's crucial to have other savings put in place before you decide to lock your extra money away. It's important to not be "cash poor," should a crisis occur.
2. You have a time horizon that is a year or more
If your purpose is to save for a short-term goal, then a 12-month CD will most likely earn more interest than simply sitting in a checking or savings account, but you can quickly cash it in when you need it without penalties.
For longer-term goals like saving for a big vacation or making future home renovations, you may want to put your money in 2-year or 5-year CD to maximize your interest and grow your savings.
Finally, as part of your retirement savings strategy, you may consider a longer term CD such as a 7-year CD or a 10-year IRA retirement CD. These offer the highest interest rates.
One way to combat interest rate risk is to consider laddering CDs. For example, to build a five-year ladder, you would buy a one-year CD, two-year CD, three-year CD, and so on until you have a total of five CDs in your basket. Each year, when one of your CDs matures, you reinvest it at the end of your ladder. A laddering strategy can help diversify your holdings and increase current income.
3. You have consulted your financial advisors to determine the best use of your savings
Sometimes a taxable CD is more appropriate to reach your financial goals and at other times a tax-free bond may be more advantageous. There are different types of CDs available, such as money market or regular CD bank deposit accounts. Make sure you understand the pros and cons of each type, how easily you can access your funds if you need them, and the terms and fees involved.
“Those with longer time horizons who are buying a CD because they have low tolerance for risk might look at CD options that link to an investment vehicle but protect principal,” suggests Dennis M. Breier, president of Fairwater Wealth Management. “However, these products are quite complex and require a fair amount of education for the buyer.”
Here are the top online banks that have highest savings accounts rates and free interest checking accounts:
When looking for a CD, it is important to consider the health of the bank you are purchasing it from and the rate they are offering. In addition to looking at the low risk and high returns of a particular bank’s CDs, review the bank’s ratings for financial strength and performance. Ideally, you’ll want to purchase a CD from an institution that is AAA rated or 5 star, which indicates a solid financial institution. Another point is to make sure you purchase a CD from an FDIC-insured bank so that your savings are protected up to $250,000.
Whether your goals are to make the most of savings account you’ve been building for years, or you’re rebalancing a high-risk portfolio, a CD can be a valuable part of your overall financial savings planning.