Once again, CD rates are back on the rise, leaving people who have decided against them in the past to reconsider whether now might be the time to begin investing in CDs once again. Before you decide whether CDs are the right choice for your investment or savings strategy and style, keep the following in mind.
As a precursor though, we will need a short vocabulary lesson for CD products, as they sometimes go by different names, depending on whether you are saving with a bank or credit union. Your bank will most likely use the term "CD" or "Certificate of Deposit." However, if you work with a credit union, they might use the phrase "term certificate" or "certificate" in talking about the same essential product. Within this article, we will use the shorthand "CD," but the term covers the credit union naming conventions as well.
Purpose of CDs
The primary purpose of a CD is to allow investors the opportunity to invest their cash in a short-term financial instrument that provides them with guaranteed interest. In most cases, the return on CDs is higher than what you will experience with savings accounts and most treasuries, making it a better place to park cash.
Over the past few years, interest rates on CDs have been unprecedentedly low. That has changed, though, making them a more attractive option to consider for investors. That does not mean it is the right choice for all investment situations.
The people who like to use CDs generally prefer them because they are considered incredibly low-risk investments. They are federally insured (up to the FDIC or NCUA up to the limit), and the rate is guaranteed. When you “purchase” a CD, you are essentially giving the bank or credit union a loan.
It works much the same as it does when you borrow money from a bank, but this time In reverse. In this case, you give the bank a specific amount of money. You agree to allow the bank to keep your money for a specific amount of time, known as the “term.” In return, they pay you a specified amount of interest on the money at the end of the term. While CD terms can be for any length of time, common term lengths for CDs are:
- Six months
- 12 months
- 18 months
- 60 months
Financially speaking, the longer the term of the CD is, the higher the interest rate you will receive and the more interest you stand to earn. Keep in mind, though, that your cash is locked up in the investment for the duration of that term unless you have a particular type of CD that allows you to withdraw your funds early without paying the penalty.
When to Use CDs
Not all savings and investment plans operate well in combination with CD purchases. There are some strategies, though, where CDs shine as investment options, including the following:
- Safeguarding savings. Some people want to protect the savings they have, and CDs offer an outstanding opportunity to do so. It is a great idea when you are saving for things like the down payment on a home or other, particular, financial goals when it is in your best interest to protect your savings. Even from yourself so you won’t be tempted to spend them on other things.
- Periods of Instability. Let's face it; the stock market is not always the safest place to keep your investment funds. While stocks may prove to offer the best return over the long term, during the short term, you might have a reasonable expectation of taking losses. During such periods, you may benefit from protecting your portfolio by moving it, or a portion of it, to cash holdings. CDs provide a useful avenue to protect your portfolio while still offering a modest return.
- Growing short-term wealth. Short-term CDs are a good idea if you have available funds to invest but either have no immediate investment in mind, or you need more cash for the investment you are planning. That can include things like saving to start a business, buy an investment property, or for other purposes. The interest CDs earn while invested is greater than they would earn in your savings accounts and all profits can be applied toward the purchase.
- Approaching that magical year. Some people invest aggressively when younger, only to transition to safer investments as they approach retirement age. It is a sound policy and one that works well with CDs. CDs are as close to “no risk” as you can get with investments. While there is no such thing as a zero risk investment, CDs represent the next best thing, allowing a virtually guaranteed return on the investment at the end of the term.
The one major drawback to consider when investing in CDs is time. A CD investment is not exactly the most liquid of your investment options since you promise the bank or credit union access to your money for a specific period. That means you won’t have access to those funds until the term expires. A strategy to minimize this drawback is to create a "CD ladder" to spread out your term lengths, giving you access to some of the funds as each term expires.
Another drawback to consider is that the return is lower than other investment options. That is the price you pay for the low-risk nature of CDs as investments.
What is the takeaway? With the right strategy in place, CDs can be sound investments, and now might be the perfect time to buy as interest rates on CDs rise again.