With interest rates slowly moving upward, certificates of deposit (CDs) are making a comeback. People are eyeing these conservative, low-risk investments as good additions to their portfolios. But what are some good strategies to help you make the most out of investing in CDs?
The last time CDs were super popular was about 18 years ago, when interest rates were around 5%. We are unlikely to see rates like we did back in 2000 anytime soon. But there are techniques we can use to maximize the great features of CDs and minimize the not-so-great features these accounts have to offer.
First off, let’s cover the basics. What exactly are CDs? (You can find a more in-depth introduction to CDs here.)
What Is a CD?
A CD is a promissory note issued by a bank, credit union or broker and sold to a customer who deposits a lump sum of money, usually $500–100,000, into an account. The bank promises the customer an interest rate that is higher than a regular savings account and guarantees that rate will remain the same regardless of market fluctuations during the term of the note. In return, the customer agrees to leave the money in the account for the specified period, usually one to seven years. They also agree to no additional deposits or withdrawals during the term. Any changes to this agreement means the customer will have to pay a hefty fee.
When you invest in CDs, your money is backed by the FDIC (or NCUA for credit unions).
A CD can be a good thing — your money has a guaranteed return, is locked into a rate no matter what the market does and is insured by the government.
It can also be a not-so-good thing. You could end up earning a low interest rate for the rest of the term if interest rates rise later. Plus, you won’t have access to your money for as long as it’s in the account. If you need that money early, you’ll pay a fee.
To make the most of your investment, here are some tips and tricks for boosting your CD savings.
Savings Boost #1: Create a CD Ladder
Instead of putting all your money into one traditional CD account, “laddering” divides your money into multiple accounts. Each account starts off with a different term length, so they all end up with staggered maturity dates.
The overall objective when you open a CD ladder is to get the accounts to mature at different times instead of all at one time. People usually set up a ladder to have one CD mature at least once a year.
This gives you access to a portion of your money sooner than a traditional CD would and gives you more flexibility. Plus, you could earn higher returns in the long run, because you’re always increasing your interest rate by rolling that money into a new CD (should rates go up) or finding better investing vehicles (should rates drop).
Here’s a basic example of how you would divide $15,000 into a 3-year CD ladder:
First, split the money into three CD accounts with varying maturity dates:
- Account #1: $5000 in a 1-year CD
- Account #2: $5000 in a 2-year CD
- Account #3: $5000 in a 3-year CD
After each account matures, roll it into a 3-year CD account making sure you get the highest competitive interest rate.
This way, you’ll have one account maturing every year.
You can find out more about the ins and outs of CD ladders here.
Savings Boost #2: Let Your CD Automatically Renew
If you’re the type of person who would prefer a hands-off approach to CDs, find a single CD account with a competitive rate and let it automatically renew on its own.
Or you could manage a ladder until the initial cycle is complete and one CD is maturing every year and then let them renew on their own.
This is not the best way to earn the most interest on your money, but it’s the least hassle. And for some people, less hassle equals less stress.
Here are some of the best rates we’ve found on CDs.
Savings Boost #3: Look for CDs With Flexible Deposits and One-Time Bump-up Features
Banks like Ally, TIAA Bank, TD Bank and USAA offer different types of CD accounts. Some accounts allow you to add money, upgrade or downgrade terms. And some let you opt for a one-time interest rate “bump” during the life of the term if interest rates go up.
These modified features break the mold of the traditional CD but come with restrictions. For example, you may earn a lower interest rate in exchange for these features, and you’ll be allowed to make only one or two changes during the life of the term.
Savings Boost #4: Stick With Short-Term Maturities (But Not Too Short)
The Federal Reserve has been slowly raising interest rates for the last few years. No one should try to predict future rates. So, it’s a good idea not to lock your money away into a CD for too long, just in case interest rates do rise.
And while I’m not a professional financial advisor, conventional wisdom says if you’re not comfortable locking up your money for long periods of time, aim for shorter terms you’re going to be comfortable with.
If you go with a CD term that’s less than a year, you’re sometimes better off keeping your money in a regular savings account, because you’ll earn more interest.
Savings Boost #5: Larger Deposits Equal Higher Interest Rates
CDs are worth it if you can make a significant deposit. The highest balances get the highest competitive interest rates.
CDs are great for bonuses, windfalls, inheritances or any money you’re okay with locking up for a while. For these you often don’t mind giving up liquidity for the higher interest.
Look for something called a “Jumbo CD” if you’ve got more than $100,000 to invest. These will get you some extraordinary rates.
Savings Boost #6: Choose an IRA CD and Save at Tax Time
A lot of people think that individual retirement accounts are limited to stocks and bonds, but that’s not the case. Several banks offer CDs that you can hold in an IRA.
One big advantage that CDs have over other retirement savings vehicles is that you don’t have to worry about all the fees that ordinarily come with using a brokerage firm for your IRA. Over time, those commissions and charges can really eat into your savings. With CDs, usually you have to pay fees only if you withdraw your money ahead of the maturity date.
Here’s another big reason to open an IRA CD: With regular CDs, you have to pay income tax on interest earned every year. With IRA CDs, that income tax is deferred as long as you keep your interest money in an IRA. You can even use it to roll into another CD once your first one matures!
If you’re feeling bullish on the stock market and want to reap the potential profits of your optimism, you might want to check out an equity-linked CD (also known as a “market-linked” or “indexed CD”). These FDIC-insured CDs are tied to the performance of a stock index (think the S&P 500). The most common term for these CDs is five years.
The financial institution that offers an equity-linked CD will calculate your rate of return on the date that your CD hits maturity. There’s no guarantee that you will receive a payment for more than your guaranteed CD rate. However, your original investment is protected, so you won’t lose your principal, as you could just by investing directly in stocks. You should also be aware that many institutions cap the returns you can glean from the stock market. So make sure you fully understand all terms before jumping in with these CDs.
Know Your Options
Don’t shop around just for the best CD rates; also look for the best types of CDs. Below are some of the different features you can find relating to certificates of deposits. Find one that fits your financial comfort level and portfolio:
- Bump-up CD — The bump-up CD (also known as a trade-up or step-up CD) allows you a one-time increase of interest rate for the remainder of the term if interest rates go up during that time. Only some banks offer this feature; be sure to find one that’s right for you. For example, Ally Bank offers a one-time bump-up feature with their 2-year CD and two bump-ups with their 4-year CD.
- No-penalty CDs — These types of CDs (also known as liquid-CDs) allow you to withdraw all your money at any time without incurring penalty fees.
- Brokered CDs — Instead of purchasing your CD through a bank, you would do so through a brokerage firm. Read the fine print to make sure your money is still FDIC insured. Not all brokered CDs are protected, and these types of CDs may lose value.
- High-yield CDs — These CDs usually have higher deposit minimums and longer terms but also offer much higher interest rates.
- IRA CDs — CDs can be opened within an IRA account (Roth or traditional). These are typically FDIC insured and have the same rules for regular CDs, like penalties and terms.
- Callable CDs — These CDs offer higher interest rates but come with risk. The issuing bank reserves the option to “call back” the CD if market interest rates drop below the rate a CD is currently earning. Thus, you could end up earning less interest on your money than expected.
Don’t just pick a CD from the first bank you know; shop around for a financial institution that offers the best features, terms and customer service. You can choose from the following types of financial institutions: