With interest rates on the rise again, some savers are starting to wonder if it makes sense to put their money into a certificate of deposit (CD) or a similar product.
After all, CD balances are usually insured by the government, keeping your principal safe. On top of that, because a CD comes with a set term, you might receive a higher interest rate in return for limiting your access to your money.
Getting a CD won’t work for every situation, but if you’re trying to figure out whether to get one, here’s when it can be a good idea.
1. You want a set rate of return
Most high-yield savings accounts, money market accounts, and other interest-bearing accounts come with variable rates, pointed out Anand Talwar, deposits and consumer strategy executive at online bank Ally. But CDs offer a set rate of return.
“A CD is a great option for a saver who wants to maximize an annual percentage yield while also getting the assurance that they are earning a consistent return on their money,” said Talwar. “Plus you don’t risk your principal.”
On the other hand, stocks come with a higher potential return. However, the returns aren’t steady and you could lose your principal in a market event. Bonds also have a higher rate of return than CDs (and they’re set), but your principal might be at risk in some cases if a company goes under.
In order to receive the highest yield on a CD, though, you need to be willing to lock up more money for a longer period of time. If you decide that you need your money sooner than expected, you could end up paying penalties to take it out of the CD.
Talwar also recommended looking into credit unions and banks such as Ally that offer bump-up CDs and other options to boost rates at least once during the term. Additionally, there are other CDs that offer you penalty-free access to your money under some circumstances.
2. You have a specific short-term goal
Dock Treece, a writer at Fit Small Business, suggested using a CD for a short-term savings goal, such as for a house down payment or vacation. With CDs, you can find terms as short as three months and as long as 10 years, allowing for variety as you save up.
For example, if you plan to buy a home in three years, you can take the money you’ve saved up so far and put it in a three-year CD at 2.45%, where you could earn $367 in interest on $5,000.
Compare that to keeping $5,000 in a savings account at 1.90%. Using our investment calculator, you’ll find that you’d only end up with $329 in interest. Weigh out the benefit of extra earnings in interest against an inability to easily access your money.
You can open new CDs as you save up more money for your down payment. Use shorter terms as you go in order to coordinate maturity dates with the time period you plan to buy your home.
3. You want cash in your investment portfolio
For the most part, said Treece, CDs shouldn’t be used in a long-term investment portfolio for purposes such as retirement — unless you’re risk averse and like to include cash in your asset allocation. Even so, it’s a good idea to limit the cash portion of your portfolio to between 5% and 10%.
A CD ladder can be one way to maximize returns over a longer time. For example, say you have $15,000 you want to keep in cash. With CD laddering, you could possibly divide up the cash portion of your portfolio like this:
- One-year CD: $3,000 at 2.30% APY
- Two-year CD: $3,000 at 2.50% APY
- Three-year CD: $3,000 at 2.55% APY
- Four-year CD: $3,000 at 2.65% APY
- Five-year CD: $3,000 at 2.90% APY
The five-year CD likely has the highest yield right now, but if rates go up, you might miss out if you aren’t willing to pay a penalty.
With the ladder, on the other hand, you have penalty-free access to some of your money after the first year. Then, you can take that money (plus the interest you earned and any other extra cash you want to include) and open a new five-year CD.
Repeat this process each year as your CDs mature. If you keep getting five-year CDs in sequence, you can keep rolling them over. And because the money is designed for your long-term portfolio, you know you won’t need the money for years. It’s a way to include cash with your investments and see a better return than you’d get in a savings account.
Are CDs right for you?
Carefully consider the purpose of your money before you lock it away in a CD. If you think you’ll need the money before the CD matures, you might be better off keeping it in a more liquid savings or interest-bearing checking account. That would help you avoid the sometimes-steep penalties that can result when withdrawing your money early.
In the end, it’s all about your long-term financial goals. CDs work best when you want a little bump in interest — as compared to a savings account — while keeping your principal safe from market changes.
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