When most people think about investing, they think of stocks, bonds, and other traditional options. However, for those who are looking for a guaranteed rate of return, another great choice exists: the Certificate of Deposit (CD for short).
As with all investments, it’s important to do research on investing in a CD (and the potential rate of return it could provide well down the line). If you’re thinking about a beginner CD – or want to diversify your portfolio with another vehicle with long-term returns – here’s what to know about investing in CDs.
What to Know About Investing in CDs
A certificate of deposit can be considered a hybrid of opening a high-yield savings account and investing in the economic market. When you invest in a CD, you are giving your bank or credit union a deposit for a certain amount of time (between six months and five years). As long as the money is held by the bank, it will grow in value at the CD’s interest rate.
Unlike a savings account, a CD is a “term investment,” meaning the fund has a target maturity date. If you request to withdraw your money before that maturity date, you may be charged an early withdrawal penalty by the bank.
HOW CDs WORK
1: An individual invests in a CD, with an interest rate and maturity date agreed upon by both the investor and the bank.
2: The bank holds onto the money similar to a bank account, and is usually insured by the FDIC for up to $250,000.
3: The investor agrees to keep the money in the CD until the maturity date, or face an early withdrawal penalty for accessing their money before.
4: At the maturity date, the investor can take the money (plus interest), or roll it over into another CD.
Pros of Investing in CDs
Perhaps the biggest positive note of opening a CD is the guaranteed interest rate for the duration of the CD. Once you agree to open a CD, your money will grow at the locked-in rate through the maturity date.
For example: If you invest $100 into a CD account with a locked in rate of 3.5% and a maturity date of three years, your investment will be worth roughly $110.87 in three years (a cumulative return of $10.87).
In addition, a CD investment is usually guaranteed by the Federal Deposit Insurance Corporation (FDIC), up to $250,000. Regardless of what happens to the bank throughout the life of the CD, your money is insured, and will be paid out either by the bank or the FDIC.
Cons of Investing in CDs
Although CDs are considered a “low risk” investment, they do come with some natural risks. Investing in a CD is not necessarily guaranteed to keep pace with the rate of inflation. Although you will earn money if the CD reaches its maturity date, your overall gains could be reduced to inflation, resulting in a net loss, compared to other investment options.
Investing in a CD assumes that you will not need the money for the life of the investment. If you decide to withdraw the money before the maturation date, the early withdrawal penalty could effectively cost you what you gained in interest, or cut into the principal based on your agreement. Before investing money in CDs, be sure to understand how much the early withdrawal fee is, and if there is a waiver for holding your money there for a set period of time.
In addition, investing in CDs may not necessarily gain a higher yield than a savings account. While you can deposit and withdraw money from a savings account (based on a variable interest rate), CDs are locked in with a deposit amount and interest rate. Once you lock into a CD investment, your deposit amount is fixed for the life of the CD.
Before investing money in CDs, be sure you are comfortable with your amount and interest rate, and are confident it is the best growth opportunity for your money. If you are unsure, you may want to consider one of the many CD alternatives in the marketplace.
Your Guide to Investing in a CD
If you decide that investing in CDs presents a long-term, stable growth investment opportunity, it’s time to look into all the factors of a certificate of deposit. Before buying in, you must decide on your deposit amount, the right term length, the early withdrawal penalty, and how to find the highest yielding CDs.
1. Decide How Much You Want to Deposit
Depending on the bank, you may have to come up with a minimum deposit amount. While some banks don’t have a minimum, others require you to deposit at least $1,000 or more. As you consider investing in CDs, start by determining how much you have to invest and if the annual percentage yield (APY) makes sense for your money.
2. Choose the Right CD Term Length
The time value of a CD is directly tied to the term and interest rate. That is, investing in CDs will effectively lock down your money for a period of time (between six months and five years) in exchange for a fixed interest rate. While shorter CD terms allow you get your money back faster, banks will usually offer higher APYs for longer investments. As you search for the right CD for your needs, be sure to understand how long you can afford to set your money aside, and how much it will earn over time.
3. Understand the Penalty for Early Withdrawal
After investing in a CD, investors are expected to keep their money with the bank until the maturity date. In the event they decide to withdraw their money before maturity, it is subject to an early withdrawal penalty. The penalty is usually equivalent to an amount of interest collected on the CD.
For example: A five-year CD may have an early withdrawal penalty of 150 days of interest. If you decide to withdraw your entire balance after three years, you will effectively lose the most recent five months of interest accrued on the CD.
If you are concerned that you may need the money invested in a CD before the maturity date – or may decide to move it to another investment option – some banks offer a no-penalty CD. Although these options usually have a lower APY compared to a more typical CD, you can withdraw it shortly after opening the account without losing any accrued interest due to penalties.
4. Shop Around For the Highest-Yielding CD
Different financial institutions offer different investment minimums, terms, rates, and early withdrawal penalties on their CDs. Before investing in CDs, be sure you shop around at a variety of banks and credit unions to find the best CD rates. Once you have found the rate and term you are comfortable with, you can more confidently invest in CDs.
Find the Best CD Rates 2020
When it comes time to find the best CD rates of 2020, you aren’t alone. We’ve taken the guesswork out of finding everything from a beginner CD to the highest-yielding CDs, based on your overall needs. Start with the table below to find the best CD opportunity for you!
- Create a retirement savings goal
- Design an investment plan to reach it.
- Get a professional money manager to continually monitor and rebalance your portfolio
Sound complicated? Don't stress. Vanguard's new robo advisor service can help you put all of this (and more!) on autopilot, all for an annual gross advisory fee of just 0.20%.