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A certificate of deposit (CD) is a stable, short-term cash investment, comparable to a traditional savings account or money market account. This federally insured savings account can be a low-risk asset in your investment portfolio, particularly if you choose one of the best CDs paying higher APY.
Key Takeaways
- A CD is a type of federally insured savings account for investing funds for a specified period of time, earning interest during that period.
- Accessing funds invested in a CD prior to the maturity date, even when allowed, often results in an early withdrawal penalty.
- One way to address early withdrawal penalties in a portfolio is to create a CD ladder.
- A CD ladder involves investing equal sums of money in multiple CDs, each with a different maturity date.
- Different types of CDs may fit investors' needs, including step-up CDs, bump-up CDs, and jumbo CDs.
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Investopedia / Julie Bang
Pros and Cons of CD Investments
Financial institutions like banks and credit unions offer CDs for savers and investors. When you buy a CD, you are essentially loaning money to the financial institution, which then pays you back in fixed, regular payments.
You keep your money in the CD for a specific period of time in exchange for a monthly interest payment. The original investment is typically returned in a lump sum on what's referred to as the CD's maturity date. A CD has several investment benefits—and potential drawbacks.
Predictable income
Even Returns
Higher interest rates
Insured deposits
Low minimum opening
Interest rate risk
Inflation risk
Funds access risk
Penalty risk
Lower returns risk
Pros Explained
- Predictable income: CDs are typically viewed as a “set it and forget” investment, meaning no ongoing monitoring is required. CDs offer investors a safe place to earn a predictable income stream, particularly if using a CD ladder strategy, described later. CDs typically offer higher interest rates than traditional savings accounts if you need to ensure access to your cash.
- Even returns: If you open a traditional CD, your interest will remain the same even if CD interest rates drop overall. For example, if you open a CD with an 18-month 4% APY, you will receive 4% APY throughout the CD's lifetime of 18 months, even if rates drop in comparable CDs or savings accounts. Just remember that the APY will reset when the CD renews, if you don't withdraw funds at maturity.
- Lower risk: The Federal Deposit Insurance Corporation (FDIC), a government agency, provides up to $250,000 of insurance per depositor in the event of bank failure. The National Credit Union Administration (NCUA) provides the same level of insurance for credit union CDs. The federal insurance makes CDs a low-risk investment that can add diversity to a portfolio invested in risker assets like stocks. You are at low risk of losing your principal (initial amount deposited), as long as you open a CD with less than $250,000 and follow the institution's rules.
- Low minimum opening: Many certificates of deposit have no minimum investment requirement or low minimums. So you don't need to save up a large amount or invest a large amount to start earning returns on your CD.
Cons Explained
- Interest rate risk: If interest rates rise, you can lose out on a higher rate if your CD hasn’t yet matured. Instead, your CD sits at the lower rate you originally received until it matures. If rates rapidly rise, you might miss out on the rate escalator unless you close the CD and pay the early withdrawal penalty.
- Inflation risk: When inflation rises, the interest you earn on a CD may not keep up with the broader economy, decreasing your spending power. If interest rates are at 3% and inflation is at 5%, your CD's value will be worth less in a year—even before you pay taxes, which you'll also owe on interest earned.
- Funds access risk: Another risk is tied to the fact that the money invested in a CD is usually unavailable to spend until the CD matures. Taking the money out early often results in a financial penalty. In addition, after maturity, there is typically a short window of time (often 7 days) during which investors can withdraw money from the CD. After that window, If you missed the window, the money is automatically reinvested in a new CD with a maturity length matching the CD that just matured.
- Penalty risk: Early withdrawal penalties can vary widely, with most providers taking a month or several months' worth of interest already earned as a penalty. Brick-and-mortar banks tend to have lower penalties than Internet banks, but regardless of institution, investors need to shop carefully and pay attention to the details.
- Lower returns risk: While CDs are safer, they likely won't grow as quickly or as exponentially as higher-risk, higher-reward investments (such as stocks) over a long period of time. A retirement portfolio made up exclusively of CDs would likely not provide enough to live on after age 65 or 70.
Portfolio Construction
Early withdrawal penalties can present both short-term and long-term investing challenges. You may have unplanned spending needs and financial developments that require adjustments to your investments. Fortunately, some strategies help address these challenges.
CD Ladders
One option is known as a CD ladder. To construct a laddered portfolio, equal sums are invested into multiple CDs, each with a different maturity date. For example, a $100,000 investment could be spread out over 10 years as follows, using a mix of 1-year CDs, 2-year CDs, 3-year CDs, and so on.
| Amount | CD Maturity |
|---|---|
| $10,000 | 1 year |
| $10,000 | 2 years |
| $10,000 | 3 years |
| $10,000 | 4 years |
| $10,000 | 5 years |
| $10,000 | 6 years |
| $10,000 | 7 years |
| $10,000 | 8 years |
| $10,000 | 9 years |
| $10,000 | 10 years |
Each maturity date can be thought of as one rung on the ladder. This strategy provides defined CD maturity dates and a specific amount of money an investor can plan to have available on each date.
The money can be used to address spending needs. Or, if it’s not needed, it can be reinvested in a new 10-year CD to extend the ladder.
This strategy also offers flexibility to deal with changing interest rates. If rates rise, extending the ladder provides access to the higher rates. If rates fall, maturing assets can be moved away from CDs and into better-paying investments.
Note
Meanwhile, assets yet to mature benefit from being invested at a time when interest rates were higher.
The Barbell Strategy
If cash will be needed for shorter-term spending needs, such as in a year or two, and then again at a predetermined longer-term period, a barbell strategy can be employed. This involves putting a specific amount of money into a shorter-term CD and a second amount into a longer-term CD. Think of it as a ladder without the middle rungs.
The Bullet Strategy
Both of the previous strategies involve investing a sum of money all at once into CDs with varying maturity periods. The bullet strategy is like buying one rung of a ladder each year. But instead of extending the ladder with each new rung, all rungs mature simultaneously in the same year.
Suppose cash is needed for a large expense 10 years from now. Then, incoming cash flows can purchase a new CD each year for 10 years. In this case,
- CD 1 matures in 10 years
- CD 2, bought a year later, matures in 9 years
- CD 3 in 8 years, and so on.
When the CDs mature simultaneously in year 10, the money can be used for the designated purpose.
Check your CD terms carefully: Some banks allow accrued monthly interest to be withdrawn before maturity, without a penalty.
CD Types
Traditional CDs are purchased and then held to maturity to avoid early withdrawal penalties. Because this model doesn’t fit every investor’s needs, there are a wide variety of innovative alternatives ranging from simple to sophisticated. Some of the more notable variations include the following.
Add-on CDs
Add-on CDs allow you to add money to a CD during the term, and may allow you to open the CD with less money than for a traditional CD. These can be a good option if you're still building a nest egg and hoping to increase your savings steadily over time. However, interest rates may be lower compared to a traditional CD.
Bump-Up CDs
Bump-up CDs provide an opportunity for investors to take advantage of rising interest rates by increasing the rate of interest paid by the CD. Shorter-term CDs are typically limited to a single increase, while long-term CDs may offer multiple increases. However, the rate may be lower than what you'd find with a traditional CD.
IRA CDs
These CDs are nested within a individual retirement account (IRA), and can be part of your retirement investments. An IRA CD may be particularly useful as you near retirement age and need a stable, lower-risk source of income and hope to preserve existing wealth. You can put your CD in a traditional IRA CD or a Roth IRA CD through a credit union or bank, if you wish.
Jumbo CDs
Jumbo CDs typically require a minimum investment of $100,000, with a higher interest rate accompanying a higher minimum investment. Maturity dates vary on the best jumbo CDs. Investors with more than $250,000 to invest in CDs should make deposits at multiple banks to ensure the FDIC protects all of their assets.
No-Penalty CDs
As the name suggests, no-penalty CDs don't charge a penalty for early withdrawal before the term's maturity date. However, fewer term options may be available—for example, only a 13-month term. The interest rate may also be lower compared to a traditional CD.
Frequently Asked Questions (FAQs)
Can I Make Money From My CD Before It Matures?
Some banks regularly pay you monthly interest before the CD matures, free of penalty. However, by doing so, you'll miss out on compound interest or earning interest on interest. Other CDs are designed to allow you to withdraw all your money penalty-free.
Should I Put All of My Money Into a Single CD?
Whether you should put all your money into a single CD depends in part on your financial goals. In most cases, diversifying your investments is widely recommended, as diversification limits your risks from any one investment. While a CD doesn't have the market risk of a stock or index fund, you still face inflationary risks and interest rate risks. It might be a good idea to spread your funds across multiple CDs maturing at different times or discuss your situation with a financial planner.
Are CDs a Safe Investment?
CDs are securely insured by the FDIC for up to $250,000 per depositor, per account. Be aware that if you need to withdraw the money early, there will be penalties. Your interest rate may also not keep up with inflation's pace or other, higher-return investment opportunities. Additionally, once a CD matures, your money could be automatically reinvested in a new CD if you don't withdraw your funds on time.
The Bottom Line
CDs can be a low-effort, lower-risk addition to your investment strategy, which can help balance out risker investments. But investing in CDs also means you may miss out on better profits elsewhere, as rates vary widely across institutions, both brick-and-mortar and online. Like any investment, Carefully review your CD options before settling on one.