What to Know before Getting a CD: No, Not a Compact Disk
A certificate of deposit (CD) is one of the many financial management tools that is a low-risk investment and has many benefits. Just like a savings account, CDs also allow you to earn interest, are FDIC insured, and there are different options to choose from. A CD will usually have higher interest rates than most savings accounts but those rates do change often.
You Should Know These Things Before Opening a CD Account
With so many benefits of CDs, it can seem like a no-brainer to get one. However, there are some things you should know before getting a CD.
How Does a Standard CD work?
When getting a CD, it helps to know how it works so you can learn how to handle money. These accounts are a form of deposit. You get a higher interest rate but you promise to keep your cash at the bank for an agreed-upon term. In return, this means you get paid an interest rate that is higher than what you would get from a savings account. You get this higher interest rate because the bank knows that they can use your money for long-term investments, such as loans. You get to decide how long you lock the money up for and the period is called a term.
Types of CDs
Before you begin the process of getting a CD, you need to know the different types.
Traditional CD
This is a popular type of CD. With this option, you deposit a fixed amount in the account for a specified term and then get a fixed interest rate. You then have the option of cashing out at the end of your term or rolling over for another term. Many institutions won’t allow you to add any additional funds before your traditional CD matures.
The penalties for early withdrawal can be stiff and it can cause you to lose interest and even principal if you withdraw too early. There isn’t a law that prevents an institution from enacting tough penalties for withdrawal fees but the institution needs to disclose those fees when you open the account.
Bump Up CD
A bump-up CD can help you from a rising rate environment. For example, if you get a two-year CD at a given rate but six months in the bank offers an additional quarter-point on the same type of investment, you have a solution. With this CD option, you can tell the bank you want a higher rate for the remainder of the term. The drawback of this is that you may get a lower initial rate than a traditional CD. It means it takes interest rates longer to rise. You should have realistic expectations about the interest rate before you choose this type of CD.
Step Up CD
With rising rates, you may want to choose a financial institution that has a step-up CD. It’s common to see a bump up CD and step up CD lumped together as the same. Both will help you get a higher yield but they are different. Instead of you having to ask the bank for a higher rate, a step-up CD will automatically increase the rates. These are not too common and there is no guarantee that you end up with a better rate than if you would have used a traditional CD.
Liquid CDs
These accounts allow you to withdraw the money without incurring a penalty. The interest rate for a liquid CD can be higher than a savings account but it may not be the same rate as a traditional CD.
Zero Coupon CDs
These accounts are similar to zero-coupon bonds. Just as with the bond, you buy the CD at a deep discount. The coupon refers to an interest payment you get periodically. Zero-coupon would mean that there aren’t any interest payments. This means you may get a 10-year, $100,000 CD for $50,000 but you won’t get any interest payments throughout the 10-year term. When the CD matures, you get the $100,000 face value.
A drawback of this CD is that they are long-term investments. You take a risk on the interest. If interest rates rise during the 10-year term then you lose out on that. Another issue is that each year you are credited with phantom income. There may not be any money in your pocket but you have to pay taxes on the earnings being accrued. You have to make room in your budget for these taxes.
Callable CD
With this type of CD, it’s possible you get a higher yield than with a traditional option but there is a risk involved. The bank that issues your CD can call it away before the CD matures. For example, you may get a five-year CD that has a one-year call protection period, then the bank could call it back after that year. The bank is shifting the interest rate risk to you.
Brokered CD
This CD is sold through a brokerage firm and in order to get one, you need a brokerage account. Getting a CD through a brokerage can be convenient. There won’t be a need to open accounts at different banks in order to get the best yields. Brokered CDs can pay higher rates than CDs from a local bank because the banks are competing in the national marketplace.
However, it’s important to note this isn’t always the case. Brokered CDs may also be more liquid than a bank CD because they can also be traded like bonds on the secondary market. There is no guarantee that you won’t take a loss. Not all brokered CDs are going to be backed by the Federal Deposit. You need to do your research and pay attention to any brokered CDs that also have call options.
High Yield CD
Banks want your business and are competing for deposits by offering better interest rates. High yield CDs can offer two to three times the national average.
Jumbo CD
Jumbo CDs require larger deposits than traditional CDs. In order to get one, you usually need to make a minimum deposit of $100,000. In certain cases, this may be lowered. Even though you are required to deposit more, you may not get more than with a traditional CD. When you put so much money into your account, there is the risk that the account doesn’t keep up with the inflation rate. You will also be taxed on the interest you earn.
IRA CD
An individual retirement account typically holds investments. IRA CDs are IRAs where you invest in CDs. These can appeal to some risk-averse savers who want to pad retirement savings with guaranteed returns. With a CD, you know how much you make as long as you keep your CD until it matures. You also have the protection from an FDIC insured institution. The tradeoff with these options is that you likely won’t have as high of a return as with other investment opportunities. CDs can be used to diversify your portfolio but it’s not always a smart retirement strategy for younger investors who are able to take on more risk.
Add On CD
Most of the CD options only let you make one initial deposit. An add on CD will let you make multiple deposits into your account during the term. The number of deposits you can make will depend on your account so you should always read the fine print.
Is Getting a CD Right for You?
When getting a CD, you need to determine how you will use the funds that you are saving. If the funds need to be used within a few months then you need to consider a money market account or a savings account instead of a CD. One smart reason to save with a CD is that you will know how much money you will earn during the term. If trying to grow your money more aggressively then there are other types of investment products that could be a better fit. Mutual funds, stocks, and exchange-traded funds could give you more money but there is also the potential to lose some of your principal.
Even if you decide that getting a CD is the best option for your financial goals, it’s not recommended that you keep all of your savings in an account. Money meant for emergency savings or a near-term purchase should be kept in a more liquid account.
What CD Is Best for You?
Even though there are different CDs, when getting a CD you need to remember that they all have something in common. With many CDs, there will be an early withdrawal penalty and your interest rate is fixed for your term. There isn’t much of a risk associated with jumbo, IRA, or traditional CDs and you are able to calculate how much interest you will get over the term.
Some CDs have more distinct terms and benefits they offer. It’s best to consider different situations that may warrant the purchase of these types of CDs. For example, a no-penalty CD can be good if you think you will need your money at some point during the term. A good example of this is if you think the stock market could take a bad turn. You can reduce your risk of locking some cash up in a liquid CD. This way, when you find a more suitable place to keep your money, you can close the CD without a penalty.
If you are looking for a higher yield, it can make sense to look at zero-coupon or callable CDs. The downside and the current economic conditions are important when looking into these options.
Considerations for Getting a CD
When getting a CD, there are different things you should consider in order to find the right situation for you.
Interest Rates
The goal when getting a CD is getting the highest rate possible. Many investors have concerns about investing in longer terms CDs because of the rise of interest rates after you have locked in a rate.
Terms of the Account
In addition to the interest rate, you also need to look at the terms, including any specific periods where your interest rate may rise. Your CD may be callable or you may need to take some initiative in order to get a higher rate.
When You Need Cash
One of the main characteristics of a CD is that you can’t access the cash during the specified term without having a penalty. Before getting a CD, you need to take a look at your current and potential financial situation. Will you need the money within the short term? If you need money within two or three years then you may need to consider other options, such as a high yield savings account. If you are interested to open a savings account, we have suggestions for you:
Withdrawal Penalties
If you do need the money before your term expires then you want to know the penalty. The penalties will range and it could be three or six months of interest. In some cases, if you withdraw your money early, you could end up with less money than when you started. A liquid CD can have lower rates but give you a time period where you can withdraw the money.
Tax Rate
The money you earn as interest is taxable. This money is usually taxed at the same rate as your wages. Those with a higher income can also be subjected to a higher tax so these individuals can be better off going with an account that is tax-exempt.
Bank Rating
You should research the financial institution where you are getting your CD. Which one has a higher user rating? Do you have experience dealing with them? It helps if you are going to work with a bank or financial institution that explains your transaction clearly, gives great customer service and answers all your questions in a timely manner.
Minimum Deposit Requirements
You need to research if the CD you are considering has any balance requirements and if you can commit to that. At some banks, you won’t be able to open up a CD with less than $1,000. Some accounts will pay more if you have a higher minimum balance.
Shop Around
If you don’t do your research first then you may have a hard time getting a good deal. Start by seeing what your existing bank is offering and then compare that to what an average CD offers. You ideally want to find something that pays higher than the national average.
Confirm the CD Is Insured
CDs can be a smart investment for when you don’t want to lose your principal. When you chose a CD at a Federal Deposit Insurance Corp. bank then you can rest easy.
Consider Bonus or Promotional Rates
The local credit union or the bank near you could be trying to get more deposits and offer you a bonus in order to keep your money there. Credit unions and banks may offer special rates that are usually reserved for larger deposits. Community banks that are hoping to build better relationships can offer CDs with attractive rates to people in specific counties or cities.
Explore All Your Product Options
With so many different types of CDs, each one can be useful in different situations. It’s important to explore all your different product options to find the right one for your goals.
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The Timing for Getting a CD
During a time when rates are going to rise, trying to time the purchase of a CD account can turn into a never-ending game. You are going to be better off making your investment based on your financial goals and how soon you will need the money you are investing in. If you are nervous about rates climbing and you being locked into a CD then choose a shorter-term account or something more liquid. You can also look into the different CD options that will let you increase the rate.
Pros and Cons of Getting a CD
When getting a CD, you will need to be aware of the pros and the cons.
Pros
Safety
CDs that are insured are safer. No one has ever lost any money invested in FDIC insured CDs.
Better Returns
Since you aren’t able to take your money back at just a moment’s notice, CDs are more valuable to banks than savings deposits.
Wide Selection of Terms
CDs have different maturities and yields from thousands of different credit unions and banks. You can find a CD with terms of three months or ones up to 10 years. With so many different options, you are sure to find one that fits your needs.
Predictable and Fixed Returns: Unlike other types of deposit accounts, you can count on CDs in order to deliver a specific yield at a specific time. Even if the interest rates are falling, the rate you agreed upon will remain constant throughout the term.
Cons
Limited Liquidity
One major drawback is that it’s not easy to access your money if an unexpected need arises. One way to increase the flexibility and to get around this is to use a CD ladder but it still may not be the best strategy if you will need this money in the short term.
Inflation Risk
CD rates will usually lag against rising inflation and drop quicker than inflation for the way down. Due to this, investing in a CD carries the danger that your money loses purchasing power over time since inflation can take over your interest gains.
Low Returns
Even though the yields tied to CDs are usually more favorable than other types of bank accounts, the returns are lower than for other investing tools, such as bonds or stocks. Since CDs are low risk, you will find the higher risk-return investments will give you a bigger return.
Re-Investment Risk
When interest rates are going downward, investors who lock in a CD rate face the choice of having to pick lower-yielding CDs when the CD matures. When rates are rising, this isn’t a problem but it may not make sense to lock into a long term CD.
Taxes on CD Accounts
Unless you have a CD as part of a retirement account, the interest you get from the CD will be taxable.
You owe taxes on interest that is not paid out. Many CD investors may be surprised to see that taxes are owed, even when there isn’t a direct payment from the CD. While it can be common to open a CD where the interest is paid out in an electronic payment or by check, there are also CDs that have the interest added back to the principal. Even if you didn’t get a check for the interest, you will still have to pay taxes.
Interest Payments
Interest from your CD can be paid on different fixed intervals, including monthly, quarterly, or yearly. If you open a CD that only pays out interest when the CD matures then you may only owe taxes on the interest the year the CD matured. You can defer the taxes for up to one year. If you have a CD that pays interest quarterly or monthly then you may have taxable interest income for two different tax years. While you can defer for a year, you can’t defer for more than one year.
Early Withdrawal
It can also impact your taxes. When you get your 1099-INT form, the bank will include the interest earned for the year, as well as the penalty on separate items. You can usually deduct the penalty, even if it is more than your interest income.
CD Strategies for You to Know
When getting a CD, there are different strategies that you may be able to utilize to make CDs work better for your financial strategy.
Getting a single CD can be an option but it may be worth it for you to get multiple CDS at the same time. CD laddering is a strategy that gives different flexibility. With this strategy, you buy different CDs with different term lengths. For example, you can build a ladder by depositing $1,000 into a 12-month, 24-month, and 36-month CD.
This means you have access to funds you can reinvest or use for different purposes. However, you will still have an opportunity to earn a higher interest rate by being able to invest in CDs that have longer terms and get more in interest.
A barbell strategy is another investing strategy and it’s similar to a ladder. However, with the barbell strategy, the middle rungs are missing. The shorter maturities make up the one end of the barbell and then long-term maturities make up the other end. You can get the most value when you go ahead and choose the longest term CD that is offered, which can usually be five years. However, it’s important to note that shorter-term CDs may have similar yields.
Another strategy you should pay attention to is to avoid automatic rollovers. You always want to evaluate your CD when it matures or it can renew at an APY that isn’t favorable. This may be especially true if your original CD had a promotional rate. Any CD that boasts a competitive APY when you first open it probably won’t when it renews.
When doing your research when getting a CD, you may want to choose an online bank. An online bank can be the best place to find the highest APY. A traditional brick-and-mortar bank may be a better choice if you prefer to meet the banker but the APY is likely to be lower. Online banks offer lower fees and higher yields because they usually don’t have the same overhead costs and then pass those savings on to customers.
Factor this into your decision. Compounding is when the interest is paid on both the principal and the interest that has already accumulated. This is included in the APY, which is why you may want to compare APYs instead of comparing interest rates. The more often your account compounds, the better. If possible, try to find CDs that compound daily. It’s the most frequent type used by banks but some other compound monthly or less often.
Final Thoughts
You may find that there isn’t much of a difference between short term CD and long term CD yields. Weigh the benefits of the APY and then consider when you will need the money. Remember, a savings deposit account yield could decrease and these rates are more variable. However, a CD will earn you the fixed APY during your entire term.
Getting a CD can be a low-risk way to save some of your money. There are different types of CDs to suit varying financial needs. A CD may not be the right choice for everyone but depending on your goals, you may be able to find a CD that works for you.
There are different considerations when getting a CD and you want to make sure you shop around in order to find the highest APY and the right terms. There are different strategies you can use, including CD laddering, for you to make CDs the right investment for you.