While certificates of deposit or CDs aren't the most exciting financial tools, they're predictable and safe.
CDs offer a guaranteed return on your money with low risk. Laura covers how CDs work, different types, maximizing income with laddering, and where to find the best offers.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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As interest rates, inflation, and market volatility climb, you may be wondering how to protect your savings. While certificates of deposit or CDs aren't the most exciting financial tools, they're predictable and safe. And that makes them an excellent place to park money for a period, depending on your financial goals.
In our last Quick and Dirty Tips team meeting, our marketing and publicity assistant, Davina, asked, "What's the deal with CDs—what do I really need to know about them?" Since it's been a while since I podcasted about CDs, I figured this would be a great time to cover them.
If you're interested in learning more about CD types, their pros and cons, when and where to buy them, and a technique called "laddering" to maximize income, stay with me!
Let's start with an overview of what a CD is exactly. It's a type of time deposit because you put money in an account and withdraw it at a specified time, known as the maturity date.
Taking money out of a CD before maturity typically comes with a penalty. So it's generally best to buy CDs only when you're sure you won't need the money until after maturity.
In exchange for giving up access to your money during a CD's term, you typically receive higher interest than with other deposit accounts. You get a guaranteed return, no matter what happens in the economy.
CD terms range from several weeks to ten years, with longer terms generally yielding the highest rates. When the term is over, you get back your principal plus accumulated interest.
While banks and credit unions generally offer CDs, they differ from savings accounts with no set term or maturity date for earning interest. However, many CDs are similar to bank accounts in that they typically come with FDIC insurance or NCUA (National Credit Union Administration) insurance if purchased from a participating institution.
Both types of federal insurance protect you for up to $250,000 per depositor, per insured institution, for each account ownership category. For instance, your deposits are covered if you have $50,000 in a savings account and $200,000 in CDs in your name. But amounts in your name above $250,000 would be at risk if the bank went out of business.
You can spread out deposits and CDs at different insured institutions to ensure you always have FDIC or NCUA coverage. And if you have joint accounts, such as with a spouse, partner, or relative, that's an additional ownership category, giving you another $250,000 of coverage.
When you begin shopping for CDs, you'll find many different types. But the three main categories of CDs are standard, specialty, and brokered products. Here's what you need to know about each.
Standard or traditional CDs allow you to deposit money for a set period, such as from 28 days to ten years, and earn interest. When the CD matures, you can withdraw your initial deposit, and the interest earned or roll it into a new CD.
Specialty CDs also allow you to deposit money and earn interest but have extra features, such as:
Brokered CDs are offered by a brokerage instead of a bank or credit union. They may have higher minimum deposit requirements, such as $10,000 or more. Brokered CDs can potentially generate much higher returns than bank CDs based on the underlying investments—but they don't come with FDIC insurance.
The primary advantages of owning CDs include the following:
The downsides of CDs are:
Now, let's discuss a strategy called CD laddering. Imagine you bought a $100,000, 5-year CD paying 4%. Now, think about how terrible you'd feel if the interest rate for a 5-year CD went up to 5% the following year. You'd miss out on earning more interest because you locked up your money at 4% for five years and can't withdraw it without paying a penalty.
With CD laddering, you buy multiple CDs with different maturity dates and interest rates. Each rung on the ladder represents a separate CD with a progressively longer term. That helps you take advantage of rising rates over time, maximizing potential earnings while keeping your savings liquid.
With a laddering strategy, you might buy five CDs with your $100,000 instead of just one. For instance, you could put $20,000 in a 1-year CD, $20,000 in a 2-year CD, $20,000 in a 3-year CD, and so on, up to a 5-year CD.
After one year, when the first CD reaches maturity, you can use all or a portion of the money to purchase another 5-year CD. So, as your shortest CD matures, you use it to buy a longer-term CD that presumably has a higher interest rate.
Laddering protects you from missing higher returns if rates rise. You earn more money and get greater flexibility. As each CD matures, you can renew it at the current rate or use your money for something completely different.
When shopping for CDs, you'll see interest expressed in two ways: APY and APR. Be sure you make an apples-to-apples comparison.
APY, or annual percentage yield, is the rate you'd receive if all the interest you earn is added to your balance or compounded. In other words, APY is the rate you get if you never withdraw interest from a CD.
APR, or annual percentage rate, is the rate you'd earn without considering the effects of compounding in that year. It's the rate you'd receive if you withdrew every penny of interest and didn't allow it to compound. When you see a CD rate that doesn't specifically say it's the APY, assume it's the APR.
The most common reason to buy CDs is when you have a relatively large amount of cash you want to keep safe while earning more than you could with a bank savings or money market account. That might be the case if you're retired, approaching retirement, too risk-averse to invest in the financial markets, or have significant short-term savings goals.
Buying one or more CDs may be worthwhile if you can lock in a great rate on money you're confident you won't need before the term ends. You'll want to consider a CD's term, APR, APY, minimum deposit requirements, and early withdrawal penalties.
If you're worried that rates might rise after you buy a CD, consider one of the specialty types I mentioned, such as a raise-your-rate or a step-up CD. They're designed to ensure you don't miss out on a higher rate later. However, getting more flexibility may mean your interest rate won't be the highest possible.
Since CDs are safe, they're great for short-term goals such as buying a home or car in a few years. However, they're not suitable for your long-term goals, such as retirement or a child's education, because you won't get enough return to build a large balance.
Remember that not taking enough risk with your money could be your riskiest move. Keeping all your money in savings or CDs means you'll likely leave a lot on the table and may not end up with enough for retirement.
Investing in mutual funds and exchange-traded funds through a tax-advantaged retirement account is the best option for achieving long-term goals and building wealth.
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Online banks have some of the highest CD rates, but you should also check rates at local community banks and credit unions; they can offer competitive CDs to attract more deposits.
I recommend using a CD interest calculator to determine how much you could earn with different CD products and compounding scenarios to reach your goals.
As I mentioned, the longer you commit money to a CD, the more interest you earn. But if you're hesitant about locking up funds, check out rates for high-yield savings, which may pay rates that approach short-term CDs without requiring you to sacrifice liquidity.
To sum up, balancing risk and reward is an ongoing struggle that all savers and investors face, especially with so much market volatility. While CDs don't offer as much return on your money, they pay more interest as rates rise and come with virtually zero risk.
Buying CDs can be wise if you're already maxing out a tax-advantaged retirement account and still have extra money for short-term goals.
I'd love you to connect with me on Twitter @lauraadams or Instagram @lauradadams. And LauraDAdams.com is my personal site where you can use my contact page and learn more about my work, books, and money courses.
That's all for now. I'll talk to you next week. Until then, here's to living a richer life.