A Certificate of Deposit (CD) is offered by most banks to customers who are looking for higher returns on their savings. Certificates of Deposit (CDs) are a great tool to save towards a goal or just park your money in a safe place for a while. Apart from a standard bank account, they are one of the few investment vehicles that are guaranteed. This is because unlike stocks and bonds, CDs are FDIC insured and aren’t subject to the ups and downs of the markets. Read this expert advice on how to maximize the benefits of using CDs to save.
- know your timeline
- know the features
- set a goal for when to use the money
- ladder your Certificate of Deposit
- understand the taxes
- use a Certificate of Deposit for your emergency fund
- treat a CD as an investment
- just settle with your current bank
- jump around
- get a CD with a long maturity date the first time
CDs all have an expiration date. There is no particular time to buy or sell a CD because they all have a fixed maturity and there is no active market where you can buy and sell them. This is part of what makes CDs so great for saving up for a goal or life event. Knowing when you’ll need the money will help you choose the right maturity date (i.e. how long the CD lasts). Once you invest in a CD, your money is completely tied up just like any other investment.
Apart from varying interest rates, Certificates of Deposit sometimes offer other perks to entice investors. A popular CD feature known as “raise your rate” allows holders to take advantage of interest rate increases without having to buy another CD. This way, if interest rates rise while you're holding your CD, your CD will begin paying you at that higher rate if you choose. This is just one example of the many special features a CD might have. You’ll also want to consider the early termination fees and any service charges associated with the CD.
Knowing how long you are willing to have your money locked away is the very first consideration when it comes to purchasing CDs. This ensures you don’t get stuck with charges for early withdrawals because you forgot about an impending expense. The next step is to think about when you actually plan on using the money. CDs are best when they are used to save towards a goal. Having a set date when you’ll need your funds allows you to use some advanced CD purchasing techniques such as laddering.
Laddering allows you to take advantage of interest rate changes and have intermittent access to your savings. Instead of buying one CD, laddering is when you buy several CDs, each with a different maturity. So one CD would mature in one year. The next in two years. Then three years. Then four years. This way you have four CDs, each maturing one year after the other. Every year you have the option of purchasing another CD to keep the ladder going or using the savings for a predetermined goal.
As with any investment, there are taxes involved. When it comes to Certificates of Deposit, the interest you receive will be taxable as ordinary income in the same way you are taxed on the interest from your savings account. The bank will issue you a 1099 detailing the interest paid to you over the year.
A mistake I often see individuals make is using CDs in their emergency fund. While CDs offer higher interest rates than money market and savings accounts, it’s important to remember that an emergency fund is ultimately a form of insurance, not an investment. You need to have access to the money immediately in an emergency fund, and CDs do not provide that kind of flexibility.
While we’ve talked about how to invest in a CD in this article, you shouldn’t think of CDs as an investment. CDs are great to use over shorter time periods of 1 to 5 years, but beyond that, inflation is going to be shrinking your money much faster than it is growing. If you have a savings goal that is more than 5 years out or you are saving for retirement, Certificates of Deposit are not the way to go.
Certificates of Deposit offer the same level of protection regardless of the bank offering the CD. All banks are regulated under the same laws and offer the same FDIC insurance. This means you can safely look at multiple banks for the best deal on a CD. It’s a good idea to shop around because smaller, lesser known banks offer better rates and terms than the larger well known banks. You can purchase CDs from smaller banks you may not have heard of before with confidence because you're getting the same level of protection as you would with a larger bank—but with better rates.
While CDs aren’t for the long haul, they aren’t for the short term either. Once you’ve purchased a CD, you need to plan on not touching that money until the CD matures. Taking money out of a CD early often involves paying fees significantly higher than the interest you’ve received. Even if you find a better CD some place else, it’s always better to wait until your current CD matures before you try and move on to the better CD.
You want to get comfortable purchasing CDs and not having access to funds. For this reason, I recommend starting out by purchasing CDs with short maturities (less than one year). While the interest you earn will be very low, it will allow you to become comfortable with the process of buying a Certificate of Deposit and planning your finances around not having access to the money. If you make a planning mistake, it’s a lot less expensive to cash out a CD with a short maturity early than it is to cash out of one with a long maturity.
So we’ve looked at all the advantages and disadvantages of using CDs to save. Since they are guaranteed, you can freely look for the best deal and rates without having to worry about taking on additional risk. Once you’ve found a good rate, ensure that you're truly ready to lock up that money for the next 1 to 5 years. If your savings goal is beyond 5 years, a CD is definitely not the best vehicle to use. Once you’ve chosen your timeline and bank, remember to consider using an advanced CD strategy, such as laddering, to maximize your runs and flexibility.