Certificates of Deposit: Pros, Cons, and Strategies
CDs offer several benefits and may be a great addition to your saving strategy.
Part one of our series on Certificates of Deposits (CDs) took a deep dive into these savings products and how they work.
In this part we’ll discuss some of the benefits of CDs, different strategies people use, as well as some things to consider before you open one.
CDs are a type of savings product that pays interest on deposited funds over a set term.
Some main advantages of CDs include potentially higher rates than other savings products and low risk to account holders.
There are a few common strategies people use to get greater returns while using CDs, including a CD ladder, CD barbell, or CD bullet.
Quick Review of CDs
To get the full picture be sure to check out our guide to CDs to learn more about the different types and how they work.
For now, we’ll just go over a few quick points on what CDs are and how they work.
CDs are savings products offered by banks, credit unions, and other financial institutions. Credit unions usually refer to them as Certificates.
CDs allow you to make a deposit and have that money earn interest, expressed as Annual Percentage Yield (APY), for a specified term, typically from as little as a month up to 10 years.1
Unlike savings accounts, money kept in CDs typically can’t be withdrawn without incurring a penalty.
Once a CD matures, you’re able to withdraw the money you deposited, along with any interest earned. When opening a CD, check how long you have to withdraw your funds after the CD matures, as some automatically renew or only give you a short window to withdraw funds.
The key benefit of using a CD as part of your savings strategy is compound interest. Compound interest is calculated not only on the initial deposit, but also on the interest the account earns over time.
Banks use APY to describe how much the money held in an account will earn over time, taking into account the effects of compound interest. APY is expressed as a percentage and is generally higher than the stated interest rate because of the effect of compounding.
Compound interest may help you retain more of your spending power during inflationary times and grow your wealth over time.
CD Rates in 2023
CD rates are influenced by many factors, including current market conditions, inflation rates, and the federal funds rate.
The federal funds rate refers to the rate commercial banks charge each other when borrowing funds.2 In general, the higher the federal funds rate is, the higher rates on deposit accounts, like CDs, tend to be. Additionally, banks tend to offer higher rates on longer term CDs as an incentive for people to leave their deposits alone for extended periods.
However, the market is currently experiencing an “inverted yield curve” meaning that rates on long-term CDs are lower than rates on short-term CDs.3
Experts are attributing this curve to the belief that rates are going to fall in the future. This expectation is encouraging banks to lower rates on long-term CDs to protect themselves if rates drop.4
Given the current climate, short-term CDs are offering higher rates and may be a useful investment if you could afford to lock funds away for a short time.
Now that we’ve reviewed the basics, let’s dive into some of the pros and cons of CDs and how they may help you achieve your savings goals.
Pros and Cons of CDs
CDs have been around for decades but have recently experienced a resurgence in popularity due to higher rates in the market.5
What makes CDs a good vehicle for saving? Let’s take a look.
Pros of CDs
There are several advantages to using CDs as part of your saving strategy, including their predictability and safety.
Let’s take a closer look at some benefits of using CDs as a savings tool:
Safety of Principal: CDs provide a secure place to store your savings. As long as they are opened through a chartered bank or credit union, they are FDIC or NCUA-insured, meaning your funds are protected in the event of a bank failure, up to the maximum allowed by law.6
Predictable Returns: With almost all CDs, you lock in a fixed rate for the duration of the term, and as long as you don’t withdraw funds, you are able to predict how much they will earn over time. Some CDs do offer variable rates, which could make it harder to calculate your potential earnings over time. Be sure to check the rate type before you open your account.
Higher Rates: Compared to most traditional savings or money market accounts, CDs tend to offer higher rates on deposits since the funds are less liquid.
Cons of CDs
While CDs offer several advantages, there are a few drawbacks to keep in mind, mainly around your ability to access these funds and potential penalties.
Let’s take a closer look at some drawbacks of using CDs:
Accessibility: Unlike savings or money market accounts, CDs typically lock your money away for the agreed upon term. This means you usually aren’t able to withdraw these funds if you suddenly need them, and if you do, you may owe a penalty.
Penalties: As we mentioned above, CDs assume that you won’t access the money until the end of the term. If you choose to withdraw the funds prior to the maturity date, you may be charged an early withdrawal penalty, which could eat away at any earnings the account may have made.
Rate Risk: While CDs usually offer a fixed rate, it’s important to be aware of what rates are doing in general. If rates are on the rise, locking yourself into a fixed rate may mean you miss out on a higher rate in the future. On the other hand, if rates are starting to drop, opening an account before they go down could help you protect your spending power in the future.
Inflation Risk: Tied in with rates, if your CD’s rate is lower than the rate of inflation, your money won’t go as far when you withdraw it.
Lower Returns: While CDs offer fairly predictable rates of return, they tend to be lower than those you may see if you invested in stocks or mutual funds. Consult a financial advisor to discuss whether CDs or other investments fit with your risk tolerance.
While all these watchouts are important to keep in mind, it’s still possible for CDs to be a useful part of your saving strategy.
CD Saving Strategies
Now that we discussed some of the advantages and disadvantages of using CDs in your saving plan, lets take a quick look at three common strategies people use to get the most out of these saving vehicles.
What is a CD Ladder?
You may have heard of a CD ladder, which is a savings strategy that may help you take advantage of different rates without locking all of your funds away for the same length of time.
The way a CD ladder works is by opening multiple CDs with different term lengths and reinvesting each CD as it matures.
For example, if you had $10,000 to invest, you may spread your money across five CDs like this:
$2,000 in a 6-month CD
$2,000 in a 1-year CD
$2,000 in a 2-year CD
$2,000 in a 3-year CD
$2,000 in a 4-year CD
As each CD matures, you would reinvest the money into a new CD, typically with a term matching the longest term in your current ladder. But you also have the option to use the funds after the CD matures if you find that you need it.
What is a CD Barbell?
The CD Barbell strategy involves splitting your funds into short and long-term CDs, without opening any midrange terms. When the short-term CDs mature, you reinvest the funds in either category, depending on where rates have risen.
Using our same $10,000 from the example above, a CD barbell could look like this:
$5,000 in a 6-month CD
$5,000 in a 5-year CD
When the 6-month CD matures, you would check rates and reinvest depending on where they had gone up. If rates hadn’t changed significantly, you’d probably choose to reinvest the funds ($5,000 + any interest earned) in another 6-month CD and reevaluate at the end of that term.
What is a CD Bullet?
A CD bullet is kind of the inverse of a CD ladder. Instead of reinvesting funds in longer term CDs over time, you open shorter term CDs over time.
Let’s look at an example. Say you want to buy a house in five years and right now you have $10,000 that you are able to put away toward that goal, so you open a $10,000 CD with a 5-year term.
Two years from now, you have a bit more money saved up so you open another CD that will mature around the same time as the first CD you opened. Perhaps you have $5,000 at that point and you open a CD with a 3-year term.
Another two years passes, and you have saved up another $3,000. This time you put those funds into a CD with a 1-year term.
By choosing shorter terms each time, all three CDs mature around the same time, meaning you are able to use the total funds to pay for your home.
Are CDs Right for You?
Depending on your unique financial situation and future goals, CDs may be a great addition to your saving strategy.
CDs often work best for people who are looking for stable rates of return and want to keep their funds in a safe place. They also may help you save toward a particular goal, such as buying a house or taking a major trip, because they lock your savings away for a specific time period and also grow during that term.
If you’re unsure if CDs are right for you, consider consulting with a financial advisor to determine the ideal approach for your specific circumstances.
At the end of the day, choosing to add CDs to your saving strategy is similar to choosing to open any new account. There are pros and cons to consider, as well as your specific financial goals.
It’s also important to keep in mind that CDs are just one option when it comes to your savings. They aren’t meant to be the only place you keep funds. Savings accounts could offer you the ability to grow your funds over time while also keeping them accessible in case of emergencies.