CDs Aren't Just for Listening to Music
Today we are talking about a different kind of savings that I’m not sure is often on people’s minds and some don’t really understand… CDs… and I don’t mean the things that play music!
A CD in the financial world stands for Certificate of Deposit. A certificate of deposit is basically a savings account offered by a financial institution that holds a fixed amount of money for a fixed period of time, which can vary. It’s also usually at a premium interest rate in exchange for leaving the money untouched during the term of the CD, so it’s a great way to grow your money safely. Some people consider a CD part of their investments. An investment is the action of investing money for profit, so both are true.
It seems to me a lot of people aren’t really aware of the advantages of this type of account.
Let’s get into what this really means and how a CD might be something that can be helpful for you and your future.
Four things to consider when looking at a CD are:
1) The interest rate
2) The term or length of the agreement
3) The principal or the deposit amount
4) The financial institution, as they determine how the terms of the agreement, like rate, penalties for withdrawals, etc.
1. Let’s start with interest rates. The rate offered on a CD, well on really any product, is up to the financial institution and the rate can vary. What that means is just because one credit union or bank offers a certain rate, it doesn’t guarantee that others will offer that same rate. Each financial institution sets their own. With that in mind, if you are interested in opening a CD, it might be a good idea to shop around and see what rates are being offered. I will say though, it really is true that a credit union will often offer higher rates and that’s not a bias because I love my credit union!
Interest rates on CDs are generally fixed. The good thing about a fixed rate is, you won’t lose any interest if rates go down, the disadvantage is that if rates to up, you won’t be able to take advantage of those.
As you consider rates, keep an eye out for special promotions from credit unions or banks where they may offer a higher rate.
2. Next is term or the length of the agreement. A length could be as short as 6 months or as long as 60 months. During this term, you are agreeing to leave the funds you deposited in your account without penalty. If you choose to withdraw your money before the term is up, you will pay a penalty for doing so. What a lot of people don’t realize is, the longer the term of the CD, the higher the penalty. If you choose to withdraw early, you will still receive any interest your investment earned up to that point minus the penalty.
When considering a term, ask yourself when you will need the money you have deposited. For example, let’s say you have money set aside for college tuition or down payment on a house but you don’t need it right away. Putting it in a CD for a time could help you earn some money before you need the money. If you need it sooner, you could choose a shorter term and if it’s for something more long term like retirement, you may be able to choose a longer term.
Most financial institutions actually prefer longer terms so you will often see higher rates the longer the term, so if you can leave the money in longer, you will see a higher return on that investment.
The key: Make sure you consider the terms AND the rates that will work for you and your situation when you are choosing a CD.
a. When the term of your CD ends, this is called the maturity date. At that point you have a few options as to what you to do with the funds.
i. You can withdraw the funds with no penalty. An easy way to do that is to have it deposited into another account of yours so you can access it.
ii. You can reinvest the money. You may hear it referred to as “rolling” the CD. This means you are going to let the money stay in the account and renew at the same term length and with whatever the current interest rate is at the time of renewal. That could be higher or lower. It depends on where interest rates are at that point. If you roll the entire amount, including the interest you’ve earned, you will compound your interest, or in other words, earn interest on the interest! Which means even more growth for your money.
iii. You can also choose to put the money in a different CD at a different term.
An important note to remember, at the time of maturity, the interest from your CD can be sent to you in the form of a check or deposited into one of your others accounts as well if you choose do that versus rolling it over for that extra earning.
Most financial institutions will offer a grace period for you to make a decision on what you want to do… that’s usually going to be 30 days before the CD auto renews.
3. Next on our list is principal, which is the amount of the deposit. The financial institution will determine the minimum amount required to open the CD. While most will require a minimum, which can be a low as a $1000, there are some that won’t require a minimum. Just make sure you ask before you decide how you want to invest.
4. The last thing on our list is the financial institution. They determine all the aspects of the agreement like early withdrawal penalties and what happens to the investment when it matures if you don’t provide instructions. Make sure you ask what the terms of the agreement are so you know what to do when the account matures.
After hearing all this, maybe you’re asking yourself if a CD is better than a savings or money market account. Well, that depends on your needs.
A money market or savings account allows you to add to your account at any time. You can also do a certain number of withdrawals a year from a savings or money market account. If you feel you will need access your money or you want to add to it, one of these accounts may be the better option over a CD.
The biggest advantage of a CD really is the interest rate. It would be rare for a regular savings or even money market account to offer a similar rate. So, if you can leave money in an account without having to access it, a CD is a great option to consider.
Speaking of rates, let’s talk about those for a minute. I’ve had people ask how interest rates are set. Not only does the length of term of the CD play a role in the interest rate, the numbers are often affected or determined by the federal rates.
If I’m honest, the entirety of how all that works get a little complicated but the short answer is a financial institution will consider the federal funds rate when they set their rates. It’s a base they use for really any account that deals with interest. So, if you see the fed funds rate go up, you may see the financial institutions follow suit. Same if they go down. I want to say though, that isn’t a given. At First Pioneers, we raised our CD rates before the fed rates went up and where others have not yet raised theirs. So, the best way to say it is, it’s a guideline not a guarantee.
If you are planning on investing in a long-term CD, and you have time, you may want to watch what’s going on with the federal funds rates as you make a decision on what terms to choose.
Besides the Federal Funds Rates, financial institutions have internal situations to consider. Let’s say your credit union’s lending has been growing and going well, they may need to bring in deposits to fund loans. So, you may see them adjust rates or offer a special to attract new deposits.
On the other side of that, a financial institution, especially really large ones, may have an abundance of deposit reserves so they don’t really need to grow their deposits or their CDs, therefore their rates may be lower.
A final tip on the federal rates: The Federal Deposit Insurance Corporation or FDIC actually has a chart that you can use to compare rates against the national average. It may give you an idea of what kind of rates are available.
Another advantage of a CD is the safety.
There are some people who prefer to invest their money in something like stocks, which comes with its own sets of pros and cons, but many people are attracted to that kind of investing because when their stocks up they have the potential for a higher return. The risk is, when they are down, you can lose not only any potential return but your investment as well.
A CD is a less risky investment… your money is safe, your return is guaranteed. Granted, you won’t have the potential for the extreme highs, but you also don’t have the potential for extreme lows. It’s a great, safe way to save for the future.
One more thing to share, there are actually several types of CDs besides the traditional ones we’ve been talking about here, but It depends on the financial institution and what they want to offer or what they can offer as to what kind they will have.
This is an overview of other common types of CDs that you may see so that you are aware of what might be out there:
1. No-penalty CDs are where there isn’t a penalty to withdraw early, but generally it will require you to withdraw the entire amount in the account if you choose early withdrawal.
2. High yield CDs will probably have the highest interest rates in your market.
3. Jumbo CDs will usually have higher deposit requirements. Often as much as a $50,000-100,000 minimum. The exception for that requirement level is most often with an online bank. You may also see a slightly higher interest rate with a jumbo CD.
4. Bump up CDs may allow you to raise your interest rate during your CD term. This is not an automatic thing though. Just because the credit union or bank raises their rates, your CD rates won’t automatically raise, you would have to ask for it.
5. Step-up CDs are what you want to look for you want your rates to rise automatically. With a Step up your rates will go at regular intervals during the term of the CD.
6. Add on CDs allow you to add to your deposit amount, or principal, during the term. You still can’t withdraw without penalty, but you can add.
7. One more type… is an IRA CD. This is CD held within an IRA. An IRA stands for individual retirement account. Some people use these with, or instead of a retirement account through their job.
There is a lot more to talk about with an IRA and we will do that another time… but for now… think of it like this, an IRA hold various investments for retirement. An IRA CD would be one of them.
This is not all the types of CDs that exist, but these are the ones you will most likely see at your credit union or bank. They may offer some variation of these and the agreements can vary.
The key is to ask questions and understand the terms of the agreement. Then make sure it fits with your financial plans.
BONUS!
How many of you have heard of a ladder CD?
It’s actually a pretty neat way to get a better return but have more opportunity for access to your funds. It takes a little planning but it could be worth it, especially if you have a larger amount to invest. Let me see if I can break this down for you.
A CD ladder is where you divide your investment into several CDs of different term lengths with staggered maturity dates. It can be an even division but it doesn’t have to be.
A traditional CD ladder model has five “rungs” with CD terms that increase by one year up to five.
Let’s say you have $10,000 to invest, it would look like this:
· $2,000 in a one-year CD
· $2,000 in a two-year CD
· $2,000 in a three-year CD
· $2,000 in a four-year CD
· $2,000 in a five-year CD
As a CD matures, put that money into a new five-year CD. After five years, your ladder will have five five-year CDs, and one will mature each year.
Here’s how that would look:
· $2,000 + one year of interest in a five-year CD
· $2,000 + two years of interest in a five-year CD
· $2,000 + three years of interest in a five-year CD
· $2,000 + four years of interest in a five-year CD
· $2,000 + five years of interest in a five-year CD
You could also do this for a four year, or even a three year ladder.
What this does, is allow you to leverage the higher interest rates on the longer-term CDs while building the ladder and to pull out 25% of the funds from the ladder per year without penalty because you will have one CD maturing each year.
The idea of the ladder and what makes it work is reinvesting each sum as a CD matures, but you can always break up the ladder if something changes along the way. Like your savings goals or interest rates that are too low. If something like that happens, you can simply move the funds into another account, like a savings account when it matures. Don’t forget, some CDs are set to automatically renew so be sure to keep track of your dates and be prepared to withdraw funds if you decide to break the ladder.
This can be a really great plan to maximize your return!
What’s the takeaway from today? A CD is a great way to safely earn a higher interest rate on your money, as long as you can go a period of time without access to the funds.
Ask your financial institution if you need help or have questions. You could also consider seeking out a financial advisor to help you look at a bigger picture if you feel you need to.
Not all financial services are one size fits all. Find what’s right for you and don’t be afraid to change if your needs change.