After accumulating enough savings to comfortably cover ongoing expenses and build an adequate emergency fund, many people start considering options for how they can invest extra money to earn greater future returns.
However, not everyone is comfortable with the inherent risks of the stock market. One option for risk-averse investors is a certificate of deposit, or CD. These accounts combine the security of a bank account with interest rates usually higher than the average savings account, which may be especially attractive in the current high-interest-rate environment.
However, there are some important factors to consider before opening a CD, and a CD may not be right for everyone.
Pros of investing in CDs
The primary advantages of CDs are security and predictable returns on deposits. When a customer opens a CD with a bank or credit union, they decide exactly how much they want to invest and for how long. In exchange for keeping their money at a financial institution for the agreed-upon time, the customer receives a fixed interest rate that is typically higher than they would find in a traditional savings account.
CD returns aren’t impacted by market fluctuations and up to $250,000 is insured by the Federal Deposit Insurance Corp. (FDIC) for federally insured banks, per account type and per depositor, just like a savings account. CDs issued by credit unions, which are called share certificates, are also insured up to $250,000 by the National Credit Union Administration (NCUA) as long as the credit union is federally insured.
Cons of investing in CDs
The main con of investing in CDs is a lack of flexibility with your funds. There are usually penalties if savers want or need to withdraw funds early to cover an unexpected expense. Early withdrawal penalties can cost a flat fee or a percentage of the interest earned, depending on the financial institution.
You’ll need to be careful when investing in CDs during changes in interest rates or you could effectively lose money. For example, if inflation rises above the interest rate on your CD during the term, you will make less on interest than inflation.
Although CDs can help protect your savings from market volatility while still earning more interest than a traditional savings account, they don’t have the same long-term earnings potential of stocks and bonds. Despite economic fluctuations, brokerage accounts may provide greater returns over time.
Is investing in a CD worth it?
The returns of a CD are tied to the federal funds rate, which is set by the Federal Reserve. The interest rate of a CD is locked at the time of purchase, meaning the returns are guaranteed even if interest rates fall during the term of the CD.
The Federal Reserve raised its federal funds target rate range to 5.25%-5.50% in July, the highest it has been since 2001. For those who won’t need access to the cash in the short term, now is a chance to lock in strong CD rates.
CDs can also be valuable for those tempted to dip into their savings accounts to make unnecessary expenses. Early withdrawal penalties should help dissuade investors from accessing money in a CD before it matures.
CDs can also be worth it for investors who don’t feel comfortable with the risk of putting their savings in the stock market. On the other hand, those who are heavily allocated to the stock market might purchase a CD to diversify the risk profile of their investment portfolio.
How to maximize returns on a CD
There are three main strategies savers can use to maximize the returns on their CDs.
CD ladder: A CD ladder allows you to earn interest over time but access your money periodically as CDs with shorter terms mature. In this strategy, the saver opens multiple CDs with staggered maturity dates. This takes advantage of the relatively high interest rates of CDs but also gives you access to a portion of your funds sooner than if it was all put into a single CD.
For example, if you have $10,000 and want to ladder that money equally, you could put $2,000 in a CD with a 6-month term, $2,000 in a CD with a 1-year term, $2,000 in a CD with an 18-month term, $2,000 in a 2-year term and $2,000 in a 3-year term.
CD barbell: A CD barbell allows you to earn some interest on short-term CDs in the near term and a much greater amount of interest on money you don’t mind tying up for the long term. Like a CD ladder, this strategy also involves spreading your money across multiple CDs. But instead of an escalating series of CD terms, the barbell strategy involves splitting money between short- and long-term CDs and excluding CDs with intermediate-length terms.
For example, you could put $5,000 in a CD with a 6-month term and $5,000 in a CD with a 5-year term.
This “best-of-both-worlds” approach allows you to access some of your money in the short term while also compounding your earnings in a higher-interest, longer-term CD.
CD bullet: The CD bullet strategy allows you to earn more interest as you allocate more of your capital to CDs over time while also maintaining some cash in your pocket in the near term. This involves opening multiple CDs over a multi-year period that will all mature around the same time in the future, making it a good option if you’re saving for a single large purchase.
For example, say you start with $2,000 in a three-year CD. A year later, you put another $2,000 into a two-year CD. And the year after that, you put another $2,000 in a one-year CD.
Alternatives to CDs
Keeping your money in a savings account is an alternative to investing in CDs and has the advantage of allowing withdrawals at any time. Savings accounts typically earn more interest than checking accounts and often require a much lower minimum deposit than CDs. However, the interest rate for a savings account is typically lower than a short-term CD and banks can change the rate on a savings account at any time.
Another alternative is a money market account, which offers interest rates comparable to a short-term CD and the same access to funds that a savings account provides. However, money market accounts also tend to have higher minimum deposit requirements than most CDs.
Frequently asked questions (FAQs)
During periods of high interest rates, a CD can provide locked-in rates that are protected from dips in the stock market. However, investing in stocks and bonds has historically provided superior returns over the long term.
CDs run the gamut when it comes to duration. Some may be only a few months long, while others can be five years or longer.
Yes, there are usually penalties for withdrawing from a CD before it reaches maturity. These can vary from bank to bank depending on the term of the CD and how early the money is withdrawn. Some financial institutions do offer no-penalty CDs.
CDs offer the same protections as traditional savings accounts — FDIC or NCUA protections on up to $250,000 per depositor, per federally insured bank or credit union, per ownership category. Because the balance and interest rate are guaranteed, and CDs do not carry the risk that comes with investing in the stock or bond markets.
In most cases, you cannot add more money to a CD once it is opened. However, some banks will allow you to add more money within a certain window of time after you open the CD.
