How to Invest In CD
Regardless of where things stand in the economic cycle and no matter what investment vehicle you choose, your single intent as an investor is to maximize the yield on your investments.
If you understand the value of maintaining a certain amount of cash in your portfolio, you may be interested in how to invest in CDs and other cash equivalents.
But particularly as interest rates hover near 0% with very little prospect of improving in the short term, investors looking for higher yields on their short-term cash investments face a problem: What is the best strategy to maximize the yield?
That is a great question.
This article explains:
- How to invest in CDs, and why you would
- How CDs work, and how to maximize your yield
- Different strategies for CDs
What is a Certificate of Deposit, and Why Invest in a CD?
IN THIS ARTICLE
A certificate of deposit (CD) is a time deposit, one of the financial products issued by banks and credit unions. It’s a particular type of account that pays a fixed rate of interest over a specific period of time.
As a time deposit, the money you invest in a CD is unavailable to you until the CD matures – and in exchange for it being “locked away,” as it were, it earns a higher interest rate than it would in a simple savings account. The trade-off of owning an instrument that is less liquid than the cash held in checking, savings, or money market accounts, then, is that CDs offer higher rates of return.
Even in a low-interest-rate environment, CDs can play a valuable role in your portfolio. That’s because they provide a stable return and are insured. The money you’re saving for a down payment on a home or other large purchase, for example, is not going to lose value just when you need it.
As rates rise, however, a CD will not benefit from that increase since the interest rate is fixed at the time of purchase. Still, CDs are a great way to invest conservatively for the short term.
How Do CDs Work?
A CD is a contract. The agreement is that you give the bank or credit union a fixed sum to hold untouched for a specific period of time and, in exchange, you’re entitled to receive both your principal and the accrued interest at the end.
Certificates of deposit pay interest earned on the maturity date, unlike savings accounts that pay interest monthly. The principal and accrued interest cannot be accessed until the CD maturity date without paying a penalty. This penalty can eliminate any gains you would receive if you held the CD until maturity.
When deposited in federally insured institutions such as banks and credit unions, CDs are insured up to the legal limit of $250,000. The $250,000 coverage is provided by the Federal Deposit Insurance Corporation (FDIC) for banks, and credit unions are covered by the National Credit Union Union Administration (NCUA).
It’s important to note that, in the rare event of a bank or credit union failure, deposits that exceed $250,000 are not covered. This means you can lose your money if your CD deposit exceeds this amount.
To make larger CD investments and still get the loss coverage, break up the CD purchases in excess of $250,000 among a few different insured institutions.
How to Invest in CDs
Certificates of deposit are great for investing toward a goal a few years (often one to five) into the future. This could apply toward a future car, home down payment, or tuition expense.
Follow these steps when selecting a CD investment:
- Determine your time frame
Match your future expense with a corresponding CD that matures close to when you’ll be making the actual expenditure. It’s important to plan the timing accurately because you will face significant penalties if you withdraw the money before the maturity date.
- Shop for CDs with the best interest rate for that time frame
Choose CDs (or bonds) that pay the highest interest rate that meets your time frame. Since banks, credit unions, and investment firms offer CDs and short-term bonds paying different rates, it pays to shop around. The next section has a great source on how to find the best CD rates.
- Verify FDIC or NCUA insurance coverage
Check to make sure you are dealing with an institution that has deposit insurance for your investment.
- Favor online banks over large banks
Online banks typically offer higher interest rates than the large, national banks.
- Read the fine print
Know the penalties if you withdraw early. These can be significant. Double-check to make sure there are no extra fees or expenses that will be charged for your investment.
- Plan what to do at CD maturity
Know what you will do when the CD matures. Will you roll it over into a new CD with a different maturity? If so, you should research CD rates before the rollover time to get the best rate available.
How Important is it to Find the Best CD Rates?
It is very important to find the best CD rates. CD-shopping is very competitive and getting the best rate that coincides with your time frame means more money would go into your pocket. Subsequently, every time you reinvest that money, you would earn more than if you hadn’t found the best CD rate at the start.
It’s also easier than ever to find the best CD rates. The best single source for competitive CD and savings account rates is to go online using the America’s Best Rates Survey. Here, you will find the banks and credit unions offering the highest CD rates for 1 year CDs and 5 year CDs.
The survey’s methodology is to average rates over an entire quarter, which is a very high standard to meet. Notably, banks that make the top ten for best savings account rates, best 1 year CD rates or best 5 year CD rates in this survey typically rank in the survey year after year.
The October 2020 survey noted that savings account rates have been falling for a record six consecutive quarters. They are now 0.25% lower than when they peaked in the first quarter of 2019. This survey also found that the CD and savings account rates offered by online financial institutions continue to be higher than those offered by brick-and-mortar institutions.
This same MoneyRates survey also noted that “In particular, avoiding the very largest national banks is an essential strategy for this low-interest-rate environment. The four largest banks in this survey all offered savings account rates that were well below average. Those large account rates represented just a small fraction of the best rates available.”
These rates change regularly, so it pays to do your research. Check this MoneyRates America’s Best Rates Survey for the latest data every quarter.
Strategies for Investing in CDs
A time-tested strategy for CD investing is laddering.
In a laddering strategy, an investor owns a series of CDs that mature at different times, commonly ranging from one year to five years into the future. This strategy provides you with cash that comes available at regular intervals, while the money invested in long-term CDs is still earning interest.
Depending on your time frame, when a CD matures, you can re-invest it in a new CD within a time frame that meets your needs. This strategy reduces the impact of interest-rate changes since your re-investment strategy is staggered.
While laddering is a traditional strategy, it has gotten a new twist. Today, some investment firms automate the CD re-investment process for you. It is now possible to build bond ladders using individual bonds, CDs, and exchange-traded funds designed for laddering as well.
What to Do When Your CD Matures
When this happens, you have a couple choices:
- You can execute a rollover strategy
- You can cash-out the CD
If you do a rollover, you can select a new maturity date that continues to meet your time horizon. Before the CD matures, go online again and check for the CD paying the highest rate that matches your time frame. Remember, to account for any taxes due on the interest earned from the maturing CD.
In a low-interest-rate environment, going for a longer maturity should pay higher rates, but this may not meet your strategy. This makes it more important to do some comparison-shopping to get the best available rate.
The other consideration depends on taxes and where the CD is held. If the CD is held in an IRA or other tax-deferred retirement plan, make sure the proceeds roll into another tax-deferred account. If not, the CD that just matured could be considered a taxable event, or even incur a tax penalty, depending on your age to retirement.
When the CD matures, find out the prevailing rates on other CDs, savings accounts, and money market accounts. Comparison-shopping could pay off.
When Are Taxes Due on CDs?
Taxes are due on interest earned and that includes CDs. The difference is if the CD is held in a taxable or non-taxable account, such as an IRA.
Since bond-laddering can be used in either type of account, it’s important to know how taxes are treated in each. In this MoneyRates article that covers taxes on CDs, investors are notified about how much in taxes they owe on their CDs. This is spelled out in the Form 1099-INT that is sent annually which notifies investors about how much they earned in interest and the amount they owe in taxes.
CD investors should be prepared to pay this annual tax bill. They can prepare for it by having the interest earned paid to them in regular distributions. This feature is available on some CDs, but you have to make this selection when you buy the CD. If not, the default option is to have interest reinvested in the CD. This means it will not be available to pay taxes.
Frequently Asked Questions
Q: I have about $20,000 split into two CDs. One is a one-year CD I got about two months ago, and the other is a five-year CD with about four years left to go. Unfortunately, I need to break into one of them early in order to pay some unexpected expenses. What should I do?
A: It’s impossible to say for sure without more specifics, but by walking through a cash flow projection, you should be able to set up a comparison for your CD accounts that will help you make this decision.
Review your CD penalty terms carefully
In most cases, you will find the early-withdrawal penalty on a long term CD larger that on a shorter-term CD. This is not always the case though, so, you need to start by taking a look at your CD terms to make sure you fully understand all the conditions surrounding the early-withdrawal penalty.
Some such penalties are stated as a percentage of the CD deposit, while others are described as a certain period’s worth as interest. That is, one CD may list its penalty as equal to 0.25 percent of the deposit, while another may list its penalty as six months’ worth of interest on the CD.
Note that some CD penalties decline or even disappear over time. Thus, if you’ve held the CD for a while, it is possible that the penalty might be less than you think it is. That probably is not the case with your CDs because you have held each for a relatively short portion of its term. But it is worth checking to see if there has been any reduction in penalty, or if you are approaching a date when such a reduction would become effective.
Once you know for certain what the applicable penalty is for each CD, calculate it in dollar terms. This is the first part of the comparison you need to make.
Weigh the penalty against lost interest
The second part of that comparison is to figure out how much interest you would lose by breaking each CD. You can only really project this for the remainder of the 1-year CDs term since you don’t know what rate you would be able to renew it for when it matures. In any case, calculate the interest you would lose for that period for each CD in dollar terms.
Now add the penalty in each case to the potential lost interest from each CD and compare the two. This will give you a fair idea of the near-term dollar impact of breaking each CD, and this comparison should help you make your decision.
Your question is a reminder that early-withdrawal penalties are something to look at when shopping for CDs. Naturally, people focus most on finding the best CD rates, but when it comes down to a choice between CDs with reasonably competitive rates, finding one with a milder early-withdrawal penalty might be the decisive factor.
