Table of Contents
- CDs fit into savings plans as a stable, secured, fairly predictable investment that can hold on their own or be used as a counterpoint to riskier investments like stocks.
- There are several different types of CDs, each with its own considerations like traditional CDs, step up CDs, jumbo CDs, and IRA CDs
- All CDs have limited liquidity, so you should only invest money you don’t need readily accessible
- Once a CD matures, you have a window to withdraw your earnings plus interest or adjust before the terms automatically renew
- Some of the best CD rates are provided by online banks or credit unions
Understanding Certificates of Deposit (CDs)
A CD or certificate of deposit is a time deposit where money is locked in for a certain period, earning interest until its maturity. The interest rate is usually fixed, meaning the CD’s rate at the start of the term will remain until maturity. Once the certificate of deposit matures, you can either roll the CD into a new term or withdraw your original deposit (the principal) along with your accrued interest.
How Do Certificates of Deposit Work?
Certificates of deposit have a set interest rate that is typically guaranteed, allowing you to chart or predict the growth over time before starting your investment. These rates vary among institutions, though online banks can often offer competitive rates since they are foregoing the cost of an in-person location. Credit unions may also have favorable rates, though these organizations have exclusive membership criteria.
It’s important to note that CDs tend to have minimum and maximum deposit limits that vary based on your investment. They are usually FDIC or NCUA insured up to $250,000.
What are the Benefits of Incorporating CDs into a Savings Plan?
CDs provide plenty of benefits, some of which include:
- Secure Investment: Your principal investment will not be depleted, and most CDs are FDIC or NCUA insured up to $250,000.
- Safety Net: CDs offer guaranteed, predictable returns, which can help balance out riskier investments like stocks or just add another sound investment to your portfolio.
- Competitive Interest Rates: Certificates of deposit often outperform traditional savings accounts, especially with online banks or credit unions. Note that they do not provide as much liquidity as traditional savings accounts.
- Fewer Banking Fees: CDs rarely come with maintenance or balance fees, maximizing interest retention. Most CDs require an initial investment of at least $500, but this can be significantly less than other investment products; making them accessible to a large swath of income brackets.
Different Types of CDs
There are several different types of CDs to choose from, each with its own set of considerations:
- Fixed Rate CD (Traditional): Traditional CDs have a fixed term and fixed interest rate, which vary from one financial institution to the next.
- Liquid CD: These CDs allow you to withdraw some money before the term date without penalty, though they are often paired with lower initial interest rates.
- Jumbo CD: As the name suggests, jumbo CDs are designed for individuals with a higher amount of capital to invest, often with minimum amounts of $100,000 or more. As a result of this higher minimum investment, these CDs usually have a higher-than-average interest rate.
- Bump Up and Step Up CDs: A step up CD provides increased interest rates across certain milestones of a CD’s term. A bump up CD provides you with a single opportunity to bump up your interest rate based on market conditions, which is sometimes called a trade up CD.
- IRA CD: CDs can be held within individual retirement accounts or IRAs. These CDs are held to the same contribution limits and considerations of the IRA, and are usually reserved for retirement.
- Callable CD: A callable CD allows the bank or financial institution to redeem the CD before the end-term date. These CDs may have higher interest rates to start, but you may be required to end your CD prematurely, depending on market conditions.
Potential Drawbacks of CDs
Certificates of deposit can be a great addition to your portfolio, but like any investment, they come with their own unique drawbacks that should be taken into consideration. The most important consideration when choosing a CD is understanding that most of these investments are not liquid, meaning that withdrawing your investment or interest before maturity may result in penalties.
There is also a possibility that you’ll lock in a low-interest rate, with inflation surpassing your set interest. This can diminish the value of your savings. Many banks also enact an auto-renewal policy, so it’s important to keep track of your term dates and rates to retain proactive control over your investments.
Tips for Integrating CDs into Savings Plans
Are you considering adopting some CDs as a component of your savings plan? Use these strategies to build a balanced portfolio with certificates of deposit:
- Consider Your Personal Financial Goals: Crafting a savings plan is a highly personal process. For instance, if you’re working up to a more substantial purchase like a car or property, you might be willing to sacrifice liquidity for a longer-term CD. On the other hand, short-term CD lengths might be perfect for saving for something specific, like a vacation or a larger expense you can foresee executing within a couple of months.
- Liquidity Considerations: It’s important to remember that during the term of your certificate of deposit, your money is not liquid, meaning that you cannot access it for the term of your CD. Withdrawing before your term is complete will result in early withdrawal penalties.
Make sure you can only tuck away what you can afford–you’ll still need emergency funds on hand to protect yourself financially, so this money likely shouldn’t be put into a certificate of deposit.
- Building a CD Ladder: One way to still benefit from the higher interest rates of CDs while maximizing liquidity is to employ a technique known as a “CD ladder”. In this method, you take a lump sum and divide it across multiple CDs, diversifying term dates and interest rates. This way, you can adjust portions of your savings as terms mature, instead of having to wait for the single sum to come back to you in full.
- Consider CD Type: There are several different types of CDs to choose from, each with its own set of benefits and drawbacks. As listed above, you can diversify across certificate of deposit types, including various financial products ranging from fixed-rate CD to IRA CDs to more flexible “bump up” or “step up” CDs.
Final Thoughts
Certificates of deposit are secure, interest-earning investments that are likely to make an excellent addition to your savings portfolio. With that in mind, it’s key to analyze your individual financial situation to ensure you select the right CD for your current and future lifestyle. You can diversify across broader investment groups, but also extend your savings across multiple CD types.
Frequently Asked Questions (FAQs)
Which type of CD should I use?
The best type of certificate of deposit depends heavily on your needs as an individual. In any case, you’ll want to carefully analyze term length, interest rate, liquidity, and your broader investment portfolio to make an informed decision.
Should I invest in a CD?
Investing in a certificate of deposit is an excellent idea for many savers, as it locks your money at a secured interest rate, backed in part by the FDIC. However, CDs do come with limited liquidity and often fixed interest rates which should be factored into your investment decision.
What are some potential drawbacks of CDs?
The largest drawback of CDs is that your money isn’t liquid. You can withdraw your funds from your CD before the expiry date, but this usually comes with a penalty fee which can eliminate some if not all of the earnings you accrued with interest.
Where can I find high-paying CDs?
We’ve crafted a guide surrounding the best CD rates of 2023 as a free resource for our readers. However, remember that while rate is important, it shouldn’t be the end all be all when selecting a CD for your needs– you should also factor in term length, liquidity, and whether the rate is fixed or has the option to shift over time.
What happens when a CD reaches maturity?
When your CD matures, you’ll have a grace period to either withdraw your earnings plus interest, or rollover your CD into another term. If you miss this period, some banks will automatically renew your certificate at the prior rate and term period.
