Investors seeking the safety of their capital will find certificates of deposits (CDs) suitable for their investment portfolio.
CDs are a type of savings instrument that locks funds for a specific period and offers predetermined returns at the time of maturity. Unlike savings accounts, CDs offer a fixed rate of interest throughout the term of the deposit.
CDs are federally insured up to $250,000, providing protection against adverse financial events.
How does a CD work?
CDs function quite similar to a savings account with one key difference; CDs have fixed interest rates for the specified term.
- Investor deposits funds in a CD for a given period. It is essential to choose a bank or credit union covered by the FDIC or NCUA.
- The initial deposit earns interest in accordance with a predetermined APY.
- At the time of maturity, the investor receives his principal investment along with the accrued interest payments.
Banks offer higher rates on CDs in comparison to savings accounts because a fixed term allows banks to utilize these funds for lending or other financial activities.
CDs come with a fixed term, although there is a provision for early withdrawal by paying a penalty fee. Banks use various parameters for calculating penalties for early withdrawals. Some banks charge a flat fee, whereas others deduct a portion of the accrued interest (2 months or three months’ worth of interest).
Understanding different types of CDs
Banks offer different types of CDs, providing a varying degree of flexibility to your savings.
No penalty CDs (Liquid CDs)
No penalty CDs or liquid CDs offer a flexible investment choice for short-term investments. There are no penalties for early withdrawals, but you lose the higher rates available in traditional CDs for this flexibility. You can shift your funds across different CDs to earn higher interest without having to worry about penalties.
Step-up CDs are certificates of deposits where the interest rates on deposits increase several times during the maturity period. These rates change automatically, allowing your funds to grow with the rising rates.
It is essential to understand that the annual percentage yield is the arithmetic average of all the interest rates. However, step-up CDs involve a withdrawal penalty, which means your funds are locked for a specific period.
Bump-up CDs are popular because of their ability to increase interest rates at least once during the CD term. Some banks may have minimum deposit requirements for bump-up CDs. Short-term bump-up CDs offer up to one boost in interest rates, whereas long-term CDs offer multiple increases during their maturity term.
You have to understand that bump-CDs typically earn lower interest rates than standard CDs because of their ability to offer higher interest rates. Check the applicable penalties in case of early withdrawal.
As the name suggests, uninsured CDs lack the insurance available in traditional CDs. However, these CDs offer higher interest rates on your invested amount. It is essential to note that in case of bankruptcy, federal insurance doesn’t cover uninsured CDs. As an investor, make sure to compare the risk against the promised benefits.
Market CDs (Bull CDs and Bear CDs)
Market CDs follow a different investing approach in comparison to standard CDs. Starting with a Bear CD, these CDs offer a higher interest rate if the linked market benchmark declines. A Bull CD, on the contrary, offers higher returns based on the upward movement of the linked benchmark index.
Jumbo CDs are suitable for high-net-worth individuals who park their excess money in a checking account or savings account. A jumbo certificate of deposit offers higher interest rates, and these funds are insured up to $250,000. While the annual percentage yield is higher for jumbo deposits, you may need to deposit $100,000 or more to open a jumbo CD. Make sure to read the penalty terms in case you want to use this deposit as an emergency fund.
What are the popular CD investing strategies?
Here are some of the most popular types of investing strategies to earn higher interest from your CDs.
CD ladder strategy
A CD ladder strategy aims to benefit from changing interest rates. The investor opens multiple CDs with varying time intervals to lock the ongoing interest rates without sacrificing the flexibility of short-term CDs.
For instance, if you’re planning to open a CD worth $10,000. Instead of creating a single CD of $10,000, create three equal CDs with time intervals of 1-year, 2-years, and 3-years. It allows you to lock the prevailing interest rates, which means even if the interest rates decline in the future, at least some portion of your portfolio will continue earning a higher interest rate.
Additionally, if you need access to funds, you can make a premature withdrawal from the CD with the shortest term.
Barbell CD strategy
A Barbell strategy strives to maintain a balance between the risk or liquidity involved in an investment. When using the barbell strategy with CDs, an investor can add short-term CDs at one end and long-term CDs at the other. This strategy provides investors sufficient liquidity through short-term deposits without compromising on the overall interest rates balanced by long-term CDs.
Advantages of CDs
- Higher interest rates: CDs offer higher APYs in comparison to money market accounts or savings accounts.
- Fixed interest rates: Most CDs lock their interest rates for the entire term of the deposit, allowing investors to earn guaranteed returns.
- Boost returns with creative CDs: Some variations of certificates of deposits allow investors to raise the rate of returns during the term of the CD, such as step-up CDs or bump-up CDs.
- Creative investing strategies: Investors can implement multiple investing strategies with CDs, including CD laddering or barbell strategies.
Disadvantages of CDs
- Lack of flexibility: Most CDs have fixed terms, which means you cannot access your money until the maturity period. Although liquid CDs offer a solution when you need funds for emergency expenses. However, they come with comparatively lower interest rates.
- Lower interest rates in comparison to other investments: CDs offer competitive returns when compared to high-yield savings account or money market accounts, but they fall short in comparison to market-related products. In some cases, the effective interest rates might be lower than ongoing inflation.
CDs vs. Savings Accounts
CDs vs. traditional savings accounts
When choosing between a CD or savings account, a CD may offer higher interest rates, but it also limits access to your funds. If you withdraw funds before the maturity date, you’re likely to lose a portion of your interest. A savings account, on the contrary, offers up to six withdrawals every month without the investor losing any interest payments.
CDs offer consistent interest rates, whereas the interest rate on savings accounts is likely to change without any prior notice. Both CDs and traditional savings accounts are insured up to $250,000, providing security of funds.
CDs vs. high yield savings account
High yield savings accounts offer competitive interest rates, along with higher fund accessibility. CDs lack the flexibility of high yield savings accounts, but they offer a fixed rate of interest throughout the term of the deposit, which isn’t the case with high yield savings accounts.
CDs vs. Money Market Accounts
Money market accounts are often considered as an alternative to CDs. Unlike traditional savings accounts, money market accounts offer higher interest rates. You can find financial institutions providing check-writing privileges and even debit cards with money market accounts.
However, most money market accounts offer variable interest rates, which could be a shortcoming for individuals seeking consistent returns. CDs, on the other hand, do not offer the same flexibility, but they offer guaranteed returns on your deposits.
At DollarGeek, our team identifies the best CD rates and terms in the market for our readers. Here are some of the best CD rates you can find in the market.