I have already discussed the importance of having an emergency fund. These funds serve as a great source of comfort for when (not if) life throws you curveballs that happen to cost more money than you can typically handle on a month to month basis.
What if you’re ready to pad your savings, apart from your emergency fund, and earn a little more interest?
INTRODUCING THE CERTIFICATE OF DEPOSIT (CD)
aka: a very low risk, slightly boring way to save money. I happen to like boring when it comes to my finances.
Ever wondered why a savings account pays so little in interest? It’s because the bank knows that we like to dip our grubby hands into our accounts, and they can’t really count on us keeping a large amount of money in there. Don’t get offended- turns out we’re pretty good at burning through our cash if we’re not careful.
Now, if we promise to keep a good chunk of cash in an account for a set period of time, this gives the bank time to lend this money to others. Be assured that they are likely making a good profit by charging higher interest rates on these loans. This is the purpose of a CD- we promise to keep our money in this account for a set period of time, and the bank will pay us a higher, fixed interest rate on this amount compared to a regular savings account.
What if we run into trouble and need to take the money out early? You will have to pay a penalty, usually a certain amount of interest that has accrued. Each bank will have a different way of calculating their penalty, and many banks will have a minimum penalty they will assess. You are always guaranteed to get your principal back though, even if you’re losing out on some interest.
A CD can be used for a future known purchase, such as a down payment on a home that you plan to buy within the next few years. Or simply having cash on hand is enough reason for people to keep their money in CDs. It is FDIC insured, which makes us sleep a little better at night.
THE CD LADDER
Worried about having your money tied up for a long period of time? This was me back when I was newly married and trying to decide what to do with our money. I was overly concerned about keeping cash tied up for any length of time, because you just never know, right? Obviously, an emergency fund could have solved this problem, but I was pretty clueless at this stage in my life. Had I known about the CD ladder, then I may have been less anxious about the idea of putting money into a CD.
The way a CD ladder works is that you open multiple CDs with staggered maturity dates. Typically, the longer the CD term, the higher the interest. After the first CD matures, you would then open another CD with the longest term in your ladder. Here’s an example using $3,000:
3 month CD at 1.5%: $1,000
6 month CD at 1.75%: $1,000
12 month CD at 2%: $1,000
Three months from now, the first CD will mature. You can then take the amount in this account, which will have accrued some interest, and immediately open a 12 month CD. If interest rates are rising, the rate will be higher than your current 12 month CD. Your initial 6 month CD now has 3 more months until it matures, at which point you can repeat the cycle.
(This example used very short term CDs. You can easily substitute these with CDs that have longer terms, like 1 and 5 year CDs.)
This way, your money is much more liquid when compared to holding $3,000 in a single 12 month CD. The math could very well work out in your favor in a climate of rising interest rates. The ladder also allows you to be flexible: when your CD matures, you always have the option to discontinue the ladder if the rates aren’t going up or you need the money for other reasons.
When researching CDs, consider the following as these can vary widely depending on where you choose to open a CD:
- Interest rates: don’t forget to look at online banks and your local credit union to compare rates
- Minimum account balance
- Your time frame: how long do you want this money tied up in a CD?
- Early withdrawal penalties
WHAT ABOUT BROKERED CDs?
This discussion has focused on bank issued CDs. There are also brokered CDs, which you would get through (wait for it) a broker. This can be a financial advisor or through a brokerage firm. The biggest difference is that these CDs can be bought and sold on the secondary market, which adds a layer of complexity and risk. Make sure you know the rules and fees before going this route.
- Typically higher interest rate than a savings account (but check around, this isn’t always the case)
- FDIC insured
- Guaranteed interest income
- A way to diversify your portfolio
- May not make much sense if interest rates are similar to high yield savings account rates
- Early withdrawal penalty if taking money out before the maturity date
- If using a CD ladder, you will need to track maturity dates and open up new accounts accordingly
- Interest earnings are taxed as regular income
Remember, CDs are not meant to “beat the market.” When you take into account the current interest rates and the rate of inflation, you’re not going to be raking in the dough with a CD. You’re just hoping to keep up with inflation and not lose any money. If that’s your goal, then CDs are a great tool to use.
Do CDs play prominently in your cash/savings portfolio? Why or why not? Have you employed a CD ladder? Comment below!