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If you are a risk-averse investor like me, you will always look for safe and secure options to generate steady income for years. I now understand why my parents loved investing in Certificate of Deposits. They enjoyed a predictable income for years and had little to worry about when it came to the safety of their money. In this guide, we talk about CDs and how they can help increase your savings.
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What is a CD?
A Certificate of Deposit (CD) is a type of savings account offered by banks and credit unions that typically offers a higher interest rate than regular savings accounts in exchange for locking in your money for a fixed period of time, known as the term or maturity period. You must understand how CDs work before you open a CD account. You start by opening a CD account with a bank or credit union and specify the amount of money you want to deposit.
You can then choose the term, which can range from a few months to several years, while the bank or credit union offers you an interest rate for the CD, which can be fixed or variable. Fixed-rate CDs offer a predetermined interest rate that remains constant throughout the term, providing stability in returns. Variable-rate CDs may have interest rates that adjust periodically based on market conditions. At the end of the CD term (the maturity date), you have several options: renew the CD, withdraw your money, or roll over the funds.
Withdrawing funds from a CD before maturity typically results in a penalty, such as forfeiting a portion of the interest earned. However, some CDs offer penalty-free withdrawal options, particularly for specific circumstances like death or qualifying financial hardships.
Better banking is here.
- No account fees
- Earn up to 4.50% APY
- Up to 2-day-early-paycheck
- No-fee Overdraft Coverage.
- Do it all in one app.
- Up to $2M of additional FDIC insurance through a network of participating banks.
Types of CDs
There are several types of CDs available to investors, each offering different features and benefits. Here are some common types of CDs:
Traditional fixed-rate CD
This is the most common type of CD, where you deposit a fixed amount of money for a predetermined period (term) at a fixed interest rate. The interest rate remains constant throughout the term, providing stability and a predictable rate of return.
Variable-rate CD
Unlike traditional fixed-rate CDs, variable-rate CDs offer interest rates that can change periodically based on market conditions or a specified index, such as the prime rate. There could be a rate increase during the term length of the CD, potentially offering higher returns if rates rise but also introducing variability in returns.
Bump-Up CD
A bump-up CD allows you to request a one-time increase in the interest rate on your CD if rates rise during the term. This feature protects against falling interest rates while allowing you to benefit from higher rates if they increase.
Step-Up CD
Similar to bump-up CDs, step-up CDs offer periodic increases in the interest rate at predetermined intervals during the term. This gradual rate increase can provide a hedge against inflation and potentially higher overall returns over the CD's term.
Callable CD
Callable CDs allow the issuing bank or credit union to "call back" or redeem the CD before it matures. If the CD is called, you receive your principal back along with any accrued interest, but you may miss out on potential future interest payments if rates have decreased. Callable CDs typically offer higher interest rates to compensate for the callable feature.
Jumbo CD
Jumbo CDs are high-denomination CDs that require a larger minimum deposit than traditional CDs. They typically offer higher interest rates than regular CDs due to the larger deposit amount.
No-Penalty CD
No-penalty CDs allow you to withdraw funds before the CD matures without penalty. While these CDs offer greater liquidity, they may come with lower interest rates than traditional CDs.
Liquid or add-on CD
Liquid or add-on CDs allow you to make additional deposits into the CD after the initial deposit. This feature provides flexibility in adding to your savings over time but may come with restrictions or limitations on the additional deposits.
CDs vs. HYSA
Many people are confused when choosing a CD and a high-yield savings account (HYSA). While both are considered low-risk investments, especially when invested in FDIC-insured banks or NCUA-insured credit unions, there are some differences you must be aware of.
Interest rates
CDs generally offer higher interest rates than traditional savings accounts and HYSA, especially for longer-term CDs. The longer the CD term, the higher the CD rates. On the other hand, HYSA offers competitive interest rates that are typically higher than regular savings accounts but may be lower than those offered by CDs.
Liquidity
CDs generally have less liquidity compared to HYSA. When you invest in a CD, your money is locked up for a fixed period until the CD matures. Withdrawing funds before maturity typically incurs an early withdrawal penalty. However, HYSA offers more liquidity since you can access your funds anytime without penalties or restrictions. This flexibility makes HYSA suitable for emergency funds or short-term savings goals.
Flexibility
CDs offer less flexibility in terms of accessing funds compared to HYSA. Once you've invested in a CD, you're committed to keeping your money in the account until the CD matures unless you're willing to incur penalties for early withdrawal. However, HYSA offers higher flexibility since you can deposit and withdraw funds as needed without restrictions. You can make unlimited withdrawals from a HYSA, making it a more convenient option for day-to-day banking needs.
Penalties for early withdrawal
You typically incur penalties with CDs if you withdraw funds before the CD matures. The penalty amount varies depending on the institution and the terms of the CD but usually involves forfeiting a portion of the interest earned. You do not incur penalties for withdrawing funds from HYSA, allowing you to access your money whenever you need it without restrictions.
Better banking is here.
- No account fees
- Earn up to 4.50% APY
- Up to 2-day-early-paycheck
- No-fee Overdraft Coverage.
- Do it all in one app.
- Up to $2M of additional FDIC insurance through a network of participating banks.
How do CDs amp up savings?
By incorporating CDs into your savings plan, you can earn higher returns on your money while maintaining safety and security. Let's take a look at how they can amp up your savings.
Higher interest rates
CDs typically offer higher interest rates than traditional savings accounts because they require you to deposit your money for a fixed period, ranging from a few months to several years.
Fixed returns
When you invest in a CD, you lock in a specific interest rate for the duration of the CD term. This provides stability and predictability to your returns, unlike other investments whose returns may fluctuate.
Low risk
CDs are considered low-risk investments because they are typically insured by the Federal Deposit Insurance Corporation (for banks) or National Credit Union Administration (for credit unions) up to certain limits, making them a safe option for preserving your capital.
Discourages impulsive spending
Since your money is tied up for a fixed period in a CD, it can prevent you from dipping into your savings for impulse purchases. This discipline can help you stick to your savings goals.
Diversification
Including CDs in your investment portfolio can diversify your holdings, providing a stable foundation alongside more volatile investments like stocks or mutual funds.
Laddering strategy
You can utilize a CD laddering strategy to spread your investment across multiple CDs with staggered maturity dates. This allows you to take advantage of the best CD rates on longer-term CDs while still having access to some of your funds at regular intervals.
CD Laddering to grow savings
CD laddering is a strategy that involves dividing your savings into multiple CDs with staggered maturity dates. This approach can help grow your savings in several ways:
- Maximizing returns. By investing in CDs with varying terms, savers can take advantage of higher interest rates offered on longer-term CDs. Longer-term CDs typically offer higher rates than shorter-term CDs. As each CD matures, you can reinvest the funds into a new one with the longest or highest APY available, maximizing your overall returns.
- Maintaining liquidity. CD laddering provides regular access to funds as each CD reaches maturity. This allows you to reinvest or withdraw funds periodically without waiting for the entire investment to mature. Having access to liquid funds can be beneficial for managing unexpected expenses or taking advantage of investment opportunities.
- Spreading risk. By diversifying your savings across multiple CDs with staggered maturity dates, you reduce the risk of locking in all your money at one interest rate or for one term. If interest rates rise, you can reinvest maturing CDs in another high-yield CD, potentially increasing your overall returns. Conversely, only a portion of your savings is affected if rates decrease.
- Flexibility. CD laddering offers flexibility in managing your savings goals and cash flow needs. You can customize the ladder by adjusting the number of CDs, the terms, and the amounts invested in each CD to align with your financial objectives and time horizon.
- Building a savings habit. CD laddering encourages a disciplined savings habit by providing a structured approach to saving and investing. As each CD matures, you can reassess your financial goals and adjust your savings strategy accordingly.
Best CD strategies
CD laddering
Divide your savings into multiple CDs with staggered maturity dates (e.g., 6-month cd, 1-year, 2-year, 3-year). As each CD matures, reinvest the funds into a new CD with the longest term or highest interest rate available in the present rate environment. This strategy provides regular access to funds while taking advantage of higher interest rates on longer-term CDs.
Barbell strategy
Allocate a portion of your savings to short-term CDs (e.g., 3-6 months) and another to long-term CDs (e.g., 3-5 years). Short-term CDs provide liquidity and flexibility, while longer-term CDs offer higher interest rates. This strategy balances access to funds with the opportunity for higher returns.
CD ladder with liquidity option
Build a CD ladder as in the traditional CD laddering strategy. Include one CD with a shorter term (e.g., 6 months) that allows penalty-free withdrawals before maturity. This option provides liquidity for unexpected expenses while benefiting from the higher rates of longer-term CDs.
Short-term CD rotation
Invest in short-term CDs with promotional or introductory rates. As each promotional CD matures, reinvest the funds into another short-term CD with a similar promotional rate. This strategy takes advantage of promotional rates while minimizing the impact of potential rate decreases.
Match CDs to future expenses
Align CD terms with upcoming financial goals or expenses, such as tuition payments, vacations, or major purchases. Choose CD terms that coincide with when you'll need access to the funds. This strategy ensures that your savings earn interest until they're needed for specific purposes.
CDs for an emergency fund
Allocate a portion of your emergency fund to CDs with staggered maturity dates. Choose CDs with terms that match different levels of emergency needs (e.g., short-term CDs for immediate expenses and longer-term CDs for larger emergencies). This strategy balances the need for liquidity with the desire to earn higher interest on emergency savings.
Reinvest interest and maturity proceeds
When CDs mature, or interest payments are received, reinvest the funds into new CDs or other investment vehicles. Continuously reinvesting interest and maturity proceeds maximizes the growth potential of your savings over time.
Ultimately, the best CD strategy depends on your individual financial situation and goals. Consider factors such as liquidity needs, interest rate expectations, and risk tolerance when choosing a CD strategy that aligns with your objectives.
Better banking is here.
- No account fees
- Earn up to 4.50% APY
- Up to 2-day-early-paycheck
- No-fee Overdraft Coverage.
- Do it all in one app.
- Up to $2M of additional FDIC insurance through a network of participating banks.
Do CDs help build credit?
Certificates of Deposit (CDs) do not directly help build credit because they are savings vehicles rather than credit products. CDs do not involve borrowing money or establishing a credit line with a financial institution, unlike credit cards or loans.
However, while CDs themselves do not contribute to your credit score, they can indirectly support your overall financial health in ways that may positively impact your creditworthiness:
- Financial stability. By investing in CDs, you demonstrate financial stability and responsibility by committing to saving and investing your money. Lenders may view this positively when assessing your creditworthiness, even though CDs do not appear on your credit report.
- Emergency fund. CDs can serve as a component of your emergency fund, providing a source of funds for unexpected expenses without relying on credit cards or loans. A well-funded emergency fund can help you avoid accumulating debt or missing payments, impacting your credit score.
- Debt management. If you use the interest earned from CDs to pay down debt or make timely payments on existing credit accounts, it can indirectly contribute to maintaining or improving your credit score. Responsible debt management, including timely bill payments, is a key factor in credit scoring models.
While CDs do not directly impact your credit score, responsible financial behaviors such as saving regularly, managing debt wisely, and making timely payments can all build a positive credit history over time. Maintaining a balanced approach to financial management that includes saving, investing, and using credit responsibly is essential to achieving long-term financial health.
The bottom line
CDs are ideal for individuals looking to earn higher interest rates on their savings while willing to commit their funds for a fixed period. On the other hand, HYSA offers greater liquidity and flexibility, making them suitable for short-term savings goals or emergency funds where immediate access to funds is important. The choice between the types of CDs depends on your financial goals, time horizon, and the risk you can take.
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