I’d like to say that the answer is not “it depends,” so let’s scope our question to “Did fighter pilots buy CDs prior 2022?” In that case the answer is probably not. But what are CDs and why should you care about them?
A CD is a Certificate of Deposit. You can think of it as a “savings account with benefits,” or perhaps as a “bond with an easy button.” A CD is like a savings account in that you give your money to a bank in order to earn interest. The bank in turn uses your money to earn profits (and keep the economy going by loaning it out). CDs have the following key features:
Fixed Interest Rate—A CD will pay a stated rate until you surrender it, or it matures.
Fixed Maturity—A CD is sold with a specific maturity period such as 3 months, 1 year, or even 5 years. It pays interest during or at the end of the period, but not after the maturity period. A $10,000 1-year CD earning 4.5% will earn you $450 by the end of the year.
Fixed Deposit Amount—CDs are often sold in specific round-number amounts and it’s normal to only add funds at the time of the CD purchase.
FDIC Insurance—CDs are sold by banks which provide FDIC insurance. This essentially makes CDs a risk-free place to stash cash.
Early-Withdrawal Penalty—CDs usually force a penalty upon you if you request your money back before the end of the maturity period.
Limited Liquidity—Because of the early withdrawal period, CDs are not as liquid as dollars in a checking or savings account.
Optional Features—Some institutions will provide bells and whistles that improve the utility of their CDs such as:
The ability to add additional funds after the initial deposit.
The opportunity to increase the interest rate if interest rates increase.
No penalty withdrawals.
Zero-Coupon feature such that you buy a CD for a discounted amount such as $900 for a $1,000 face value CD, and then receive $1,000 at maturity. When you receive the $1,000, $100 is interest.
Callable—the bank can terminate the CD early if interest rates drop.
Brokered—the CD is purchased through a brokerage (e.g., Schwab, Fidelity, Vanguard, etc.) rather than your bank.
Aren’t CDs for my Grandparents?
Until the recent interest rate runup, CDs had been paying interest rates that were wildly uncompelling. Like most other cash vehicles (money market accounts, Treasury bills, high-yield savings accounts, etc.) CDs were paying rates with too many zeros before and after the decimal to be interesting. Even with 2% inflation, a CD earning .005% per year just isn’t sexy.
However, the rising interest rate environment we find ourselves in today has the silver lining of higher CD rates. At the time of writing, rates for 1-year CDs are well over 4.6%, and 6-month CDs are closing in on 4.4%. With the Federal Reserve expected to continue its rate hikes well into 2023, we’re likely to see CD rates climbing too.
So yes, CDs like Series-I Bonds, have not been interesting for a lot of years, but they are having their day in the sun. They might not just be for your grandparents anymore.
How to Buy CDs
There are three main methods for buying a CD. The easiest option is usually to go to your bank’s website, check their rates and click “buy a CD.” You’ll be able to move money from your checking or savings account and lock in a CD with a few clicks and about five minutes.
The second option is to search the internet for the banks offering the best rates. Bankrate.com is a great aggregator for information on interest rates for all types of accounts. You must sift through advertisements that might seems a little baity-switchy, but without much trouble you can find (mostly online) banks with the best current rates based on the maturity you’re interested in. You’ll need to open an account with the new bank and transfer funds to it from your current bank.
The third option can be very easy, usually has the best rates, but also has the highest risk of buyer’s remorse—a brokered CD. A brokered CD is bought at your favorite investment brokerage (e.g., Schwab, Vanguard, Fidelity, etc.) inside your taxable brokerage (or even IRA) account. You’ll need to comb through offerings from dozens if not hundreds of banks. Your brokerage’s search tools may not be user-friendly and you’ll have to watch out for issues like:
Callable: If you want a 1-year CD, but the bank can call it at 6 months, it’s because the bank thinks rates might be lower in 6 months. You’ll miss out on interest that you wanted.
Minimum Purchase: Brokered CDs are usually listed at a price of “100” which you can think of as 100% of $1,000—i.e., they’re really sold in units of $1,000. If you want to save $10,000 in brokered CDs, you’re probably buying ten units. Some banks have minimums higher than 1 ($1,000).
Specific Amounts: If you want to save $10,500 in a CD, you’re probably going to do that at your bank or credit union. Brokered CDs are purchased in round numbers, typically increments of $1,000.
Specific Contract Dates: Brokered CDs usually start and end on a specific date. I.e., a 6-month CD that you buy today may actually initiate next Tuesday and have a maturity that is pretty close, but not exactly 6 months later. Mind the dates.
Specific Interest Terms: Brokered CDs can have different terms for interest payments and probably don’t pay monthly. Some may only pay at maturity.
Pre-owned: Brokerages may be offering CDs that are already in force and paying such that the maturity is an odd date, and the price is a discount or premium of other new CDs because either interest has already been paid out or changes in the prevailing interest rates affect the price of in-force CDs.
State-laws: Some CDs can’t be purchased by residents of some states.
No Rollover: Bank CDs typically automatically reinvest in a CD of the same duration with the prevailing interest rate when they mature. Brokered CDs do not have this automatic feature.
If you’re seeking the best return on your cash, brokered CDs are worth learning about, but you can be forgiven for feeling overwhelmed by the purchase factors!
Where do CDs Fit in my Cash Planning?
So, you’re convinced that the .000000001% you’re currently getting in your savings account isn’t exactly helping battle inflation, but when should you consider the workload of adding additional accounts and potentially financial institutions to your already busy life?
Let’s assume a vanilla bank CD that has fixed maturity, pays interest monthly, and charges a 10% penalty for early withdrawal. (10% of the earnings to date, not the principal) Use cases for such a CD might be:
Car savings: You can estimate when your next car purchase will be. You can layer CDs to mature at that time.
Vacation savings: Same story. If you’re going to feed Benjamins to the rat, you know when. Why not earn some interest until then? (The rat will let you spend the interest on him too…)
Education payments: Owe tuition in 6-12 months? Hopefully the money isn’t in the stock market, but you can earn some return until you pay the school.
House down payment: This is perhaps one of the best uses right now. Again, you know when you might need to deploy cash to buy that house. If it’s inside 5 years, a CD could be a great option.
Emergency fund: While you may not want to lock up all your emergency fund in a CD due to the limited liquidity, it’s not unreasonable to keep at least part of it in a CD if you have other temporary sources of capital such as other cash, a credit card or even home equity line of credit. Pay attention to your CDs early withdrawal terms.
CDs are less appropriate for monthly spending accounts, and you can’t spend directly from them anyway. You need to move the money back to your checking account at the CD’s maturity.
Other Devilish Details
Interest rates change. If you’re trying to decide between a 6 month CD paying 4.5% and 1-year CD paying 5%, you might be hoping that at the 6-month point, rates go up and you can buy a new 6-month CD for 5.5% or more. That would be swell. But if rates drop and the best available CD at the 6-month point pays 4.0%, you lost a whole 1% for the second 6 months.
A CD ladder is a technique where you might invest 1/3 into a 6-month CD (4%), 1/3 into a 1-year CD (4.5%), and 1/3 into an 18-month CD (4.75%) in hopes that you might reinvest at higher rates at the 6 and 12 month intervals, but if rates go down, at least some of your money is earning at the highest rate.
Ladders are also helpful for aligning the availability of your funds with your expected need date. If you’ll need to make payments on a construction project for your forever home, laddering CDs based on scheduled payments can optimize interest earned.
CDs pay interest which is taxed at your ordinary income rate (e.g., 22% or 24%). While you may be fighting back against a bit of inflation, Aunt IRS still expects her cut.
The auto-reinvestment feature may be undesirable. If you leave your bank CD on autopilot, you may find your money tied up with Nerf handcuffs at the end of the maturity period. You probably won’t lose interest you’ve previously earned to free it up, but every CD’s early withdrawal terms are different.
Alternatives to CDs
CDs are pretty easy to navigate, but they’re not the only cash account paying attractive interest. Treasury Bills are paying similar rates for short-term bills at www.treasurydirect.gov. Many money market and high yield savings accounts are paying within a percentage point of CDs, but have greater liquidity.
Bonds can be more complex than CDs to purchase and they carry more risk without any sort of insurance, but they often pay higher rates.
Finally, if your savings goal is beyond 5 years, diversified funds of stocks and bonds remain your best bet to beat inflation in the long run.
Cleared to Rejoin
CDs have been in the wilderness for over a decade, but they’re back with risk-free interest to help fight inflation. If you’re sitting on cash that you don’t expect to need for even a month, a CD is worth considering. Up to a point, the longer CD maturity you purchase, the higher interest rate you can earn. CDs can have a little complexity when you’re first deciding how to integrate them into your financial arsenal, but they’re pretty simple to buy and own overall. If you’re not considering CDs, it’s time to ask yourself, “Self, what are we going to do to put our cash to work?”
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