Choosing the Right CD for Your Financial Goals
February 6, 2020
A CD (certificate of deposit) is a set-it-and-forget-it kind of financial vehicle. Interest rates are modest, there’s virtually no risk, and they don’t involve any interaction, so they’re the perfect option for a truly conservative, hands-off investor.
A Certificate of Deposit (CD) is a safe investment that can be the perfect way to grow your money predictably. When you are looking for a short-term and reliable investment option that offers a higher return than a typical savings account, CDs can be a great option.
Different CD Types
A traditional certificate of deposit allows you to deposit a fixed amount at a fixed interest rate for the duration of the term. There are also other types of CD that you might look into:
- Bump-up CDs — if you want the benefits of a long-term CD but are worried about missing out on a rise in interest rates, a bump-up CD allows you to upgrade to a higher interest rate in the middle of your term.
- Indexed CDs — the returns of an indexed CD are tied to a particular market, such as the S&P 500 or to a bond, currency, or commodity price. Indexed CDs offer potentially higher returns, but returns may also decrease in line with market changes.
- Callable CD — a callable CD usually has a longer term and a higher interest rate than a standard CD, but also allows the bank to “call” the CD, ending its term early, at their discretion. For example, if a bank issues callable CDs at a rate of 10 percent, and then interest rates drop significantly, the bank reserves the right to cancel the CD and potentially reissue it at a lower rate.
Picking the CD That’s Right For You
If you do decide to take advantage of the security and predictability of a CD as an investment option, there are several choices to make – each with their own advantages and disadvantages. Here’s what to consider:
When you open a CD, it’ll be effectively off-limits until the end of the term. Think about how long you can afford to live without the money — is it extra cash you can live without, like a retirement fund? Or do you anticipate making a significant purchase in the next year or two, like a vacation or a car, for which you might need it?
The interest rates offered on CDs are closely tied to the interest rates set at the Federal Open Market Committee (FOMC), which fluctuate from year to year. In the last five years, that rate has been as low as 0.06 percent and as high as 2.44 percent. It’s hard to predict what will happen to rates going forward; though, as of May 1, rates have already been cut twice in 2020.
If you think a rate hike is likely, you’ll want to use a short-term CD account so you can cash out quickly, then open a longer-term CD when rates go up. If you anticipate a rate cut, then it’s a good idea to lock in a long-term CD now.
One of the benefits of a CD is that the rate is predictable. If your money is earning 1.9 percent in a money market or savings account and the interest rate dips, you’re susceptible to that rate drop. If your money is in a CD, it will earn the same return for the duration of the term, no matter the external rate environment.
Long term CDs generally offer a higher rate of return than short-term ones, but they also lock up your money for longer than you might like. To get the best of both worlds, some customers opt to open multiple CDs in a technique called laddering.
Imagine you have $50,000 to invest.
- On January 1, 2020, you would deposit $10,000 each into a 12-, 24-, 36-, 48- and 60-month CD.
- On January 1, 2021, the first CD will mature, and you can reinvest it into a 60-month CD with a better rate.
- A year later, the second CD will mature, and you can do the same thing.
After five years, you’ll have a rolling set of five deposits at relatively high interest rates. These CDs mature annually, allowing you to reinvest the money or spend it if you need it. You get the best of both worlds — the liquidity of a 12-month CD with the interest rate of a 60-month.
The intent of a certificate of deposit is that you’ll leave it alone for the full duration of its term, so most banks have early withdrawal fees for taking your money out early. If you withdraw the money from a 36-month CD early, you might sacrifice 90 days of interest, for example.
There can be advantages to withdrawing your money early. If you have the opportunity to take advantage of higher interest rates, you might net more earnings overall by pulling your money and reinvesting it.
When your CD’s term ends, you’ll have the option to accept the payout as cash or have it automatically redeposited as a new CD with the same terms. Though automatic rollover is the most convenient option, it’s not always the best way to maximize your money.
If interest rates have gone up, for example, it makes more sense to reinvest the money from your CD in one with better terms. Shop around when your certificate of deposit is about to mature to see if a rollover is right for you.
Benefits of a CD
When you’re trying to decide if a CD is right for you, we take your entire financial situation into account, but the most important aspect to consider is your short- to mid-term income and expenses. It’s important to remember that you can’t get money out of a CD before it matures without paying (sometimes significant) penalties, so you need to be confident that you won’t need that money until the term has expired. If your income is unpredictable, a CD might not be the best solution for you.
Keep Up With Inflation
If you leave money in a checking account, you’re earning no returns on it. Given that typical U.S. inflation is around 1.9 percent a year, that money will be losing its spending power at roughly the same rate.
You could put that money in a brokerage account or other investment vehicle, but most investment options carry risk. If you’re sure that you need the money in a few years, you might not want to risk losing value on a significant market downturn.
A CD is a good middle ground, allowing you to set money aside in a completely reliable, certain investment vehicle while also generating a small return. Let’s say you have a child in high school and you know that in two years, you’ll be writing a check for roughly $50,000 in tuition to their college of choice. You have the money on hand, but if you leave it in a checking account, you’ll lose spending power over the course of two years of inflation.
If you put that money in a CD at a rate of 2 percent, it won’t lose any value and it’ll keep pace with inflation, ensuring that the spending power of your money doesn’t diminish over time. It’s also completely safe — CDs are insured by the FDIC, so there’s no risk involved.
Another area where our clients also take advantage of CDs is in retirement planning. If you’ve already accumulated the wealth you need to retire, you might not want to risk it by leaving it in a brokerage account. Instead, you can set up a CD ladder with your funds, keeping them reasonably liquid while also preserving them from risk.
Ask the Experts
Financial planning can be overwhelming — luckily, we’re here to help. For nearly 20 years, we’ve been offering a combination of integrated financial guidance and personalized boutique service. If you’re wondering what the future holds for you and your money, or you’re not sure what your best options are, contact us by phone or stop by a First Western Trust Bank branch in Arizona, Colorado, California, or Wyoming.