How You Can Save with Certificates of Deposit (CDs)

what is a CD

Today, we are in a low-rate environment.

Even though the Federal Reserve recently issued a rate hike, we’re still looking at much lower rates than what we saw prior to the financial crisis of 2008.

I remember the days (in 2005) when I could earn a yield of 5% on my online savings account. Today, I’m happy to be earning 1%.

For those looking for a little extra yield on their money, a “regular” savings account might not cut it, and investing might feel too risky. If that’s the case, you might benefit from using certificates of deposit (CDs) as part of your savings strategy.

What is a CD?

A certificate of deposit (CD) is considered a timed deposit. That means it has a set expiration date, and, usually, a fixed yield. You agree to keep the money in the bank for a specific period of time. In return, the bank promises a higher rate of return. With a CD, the longer you agree to leave the money in the bank, the higher your annual yield.

Once the CD matures, you can withdraw your original principal, plus the interest you earn. While it’s possible to withdraw money before the maturity date, you usually end up paying a penalty. The idea behind a CD is that you give up some of your liquidity in return for a higher rate of return.

Safe returns with CDs

Savers like CDs because they come with safe returns. When you open a CD, it’s protected by FDIC or NCUA insurance for up to $250,000. This means that if the bank or credit union fails, your money is still safe.

Even though you can usually get a higher return than with a savings account, you’re still not getting a great return. You are usually lucky to keep pace with inflation when you use a CD for savings.

CDs can be a part of your overall portfolio and savings plan, but they are unlikely to help you build wealth at a fast enough pace to allow you to retire. You usually need to add investments to the mix in order to meet your retirement goals.

What is a CD maturity length?

Maturities vary for CDs. You can actually get CDs with a maturity date as close as one month away. If you want a higher yield, though, you need to lock your money away for longer. You can typically get better current CD rates with a five-year term.

For example, according to Bankrate, you might see an annual percentage yield of 0.96% on a nine-month CD. However, a five-year CD might offer you a yield of 2%.

Some banks also offer what they call IRA CDs. In many cases, these CDs come with maturities of between six and 10 years. You can usually get a pretty decent yield on these CDs. It’s possible to find current CD rates of up to 3%.

However, it’s important to note that these IRA CDs are regular CDs held in a tax-advantaged retirement account. Even after the maturity date is reached, you can’t withdraw the money. You need to wait until you reach retirement age because you are subject to those rules.

It is possible to use the money to purchase another CD within the IRA. Speak to your retirement account custodian if you want information on purchasing another CD inside your IRA.

Jumbo CDs

One way to boost your yield is to open a CD with at least $100,000. This large CD is called a jumbo CD. A jumbo CD is usually available in the same maturities as a “regular” CD.

With a jumbo CD, you can find current CD rates of more than 2%, especially if you are willing to keep the money in the bank for at least five years. Plus, since you start with a higher principal, it means bigger returns.

What is a CD ladder?

One of the most popular ways to use CDs is by laddering. The theory behind laddering is simple: you divide your money into equal parts and buy CDs of different maturities. When the first CD matures, you use the money to buy a longer-maturity CD.

The idea behind laddering is to try to maximize yield. One of the downsides of locking in a long-term CD rate is that you miss out if rates rise. In order to reduce this risk, you open some CDs with shorter terms. As they mature, you use the money to purchase new, longer-term CDs.

Long-term CD laddering

If you hope to save for the long-term using CD laddering, it’s common to use a five-year plan. Say you have $15,000 to put into CDs. Divide that money into five equal parts of $3,000. You open a one-year, two-year, three-year, four-year, and five-year CD. Now you have five different CDs with different maturities.

You’re not going to receive a very high yield on the CDs with lower maturities. You’ll get the best of the current CD rates on the five-year CD. When the one-year CD matures, you use the money to buy a five-year CD. Now you have access to the best current rates, and can take advantage if interest rates have gone up.

If you buy a five-year CD one year into your plan, it will mature during year six of your ladder. Keep buying five-year CDs going forward, and you have a way to keep buying CDs at the best current CD rates.

Short-term CD laddering

The same principle works with short-term CD laddering. The idea behind short-term laddering is to create emergency savings.

Instead of putting your money CDs that mature every year during your ladder, you can set them up to mature every couple of months. This is a little trickier, since you want to make sure you’re getting into a rhythm that allows you to take advantage of year-long rates.

One way to do it is to get maturities of three, six, nine, and 12 months. You divide your money into four CDs, rather than in five. Once your first CD matures, you use the money (principal plus interest) to buy a 12-month CD. That way, you have a situation where you have access to the money every three months.

This can be a way to boost your overall yield on your emergency savings. You won’t see the same returns as long-term laddering, but at least you get access to your money, the best current CD rates for low maturities, and a better yield than a savings account.

Promotional CDs and higher yields

It is possible to see higher yields on CDs when you look for promotional products. These are CDs designed to entice you with higher yields. However, you need to be careful. While you can get higher yields initially, some of the terms can be confusing and result in a loss.

Bump-up CDs

A bump-up CD is one that allows you to take advantage of rising rates before your maturity date. This is supposed to be a way around the fact that you lock in rates with CDs and can miss out on interest rate increases.

The problem with bump-up CDs is that there are often terms and conditions. You might start with a lower interest yield. This means that rates might not rise enough for you to overcome the spread before the maturity. Other conditions, like matching maturities, might apply if you want to bump your rate higher.

No-penalty CDs

Cashing in early on your CD means a penalty – unless you get a no-penalty CD. This seems like a good idea, but, as Bankrate points out, no-penalty CDs come with a host of conditions. You might only be able to access the money if you’re laid off. The yields might be lower than counterparts with penalties or you might have a higher minimum deposit.

Market-linked CDs

Believe it or not, there are CDs that are actually linked to the markets. Sometimes these are called index CDs. These are CDs that offer higher yields based on what’s happening with a particular index. Your CD could be linked to stocks, bonds, currencies, or something else.

The FDIC points out that you could end up with losses, since not all market-linked CDs are protected by the FDIC. Double-check to see if the principal is at least protected. Additionally, realize that some of these CDs require a commitment of as many as 20 years.

There are a lot of restrictions with market-linked CDs, so it’s important to understand what you’re getting into.

Callable CDs

A callable CDs are another promotional CD product that can offer potentially higher yields. However, the downside is the issuer can call the CD before it matures. Investopedia says that it can mean higher rates now, but you could see lower rates later.

The issuer sets a timeframe that allows it to return the CD to you, plus the interest you’ve earned. You can get a new CD, but there’s a good chance you will receive lower returns for the money.

If you have a five-year callable CD at one year, that means the issuer can give the money plus earnings back to you at the end of a year, if it wants. Some issuers offer higher initial rates on callable CDs. But if the interest rate environment changes and rates drop, after a year, you might see the CD “called in.”

Even if the issuer decides not to call the CD in on that year mark, the callable CD can still be called in each year, on your anniversary of opening, until maturity.

Should you use CDs for saving?

CDs aren’t right for everyone. Look at the risks and rewards and see if they work for you. They can have a place in a long-term portfolio, though. While you don’t want to rely on cash savings products to build your entire retirement nest egg, it can help.

With CDs, the cash portion of your asset allocation can potentially earn higher yields than if it just sat in a regular savings account.

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