Another Savings Bucket: Understanding Certificates Of Deposit (CDs) – A Beginner’s Guide
When you think of saving money, the first thing that probably comes to mind is your regular savings account or maybe even a High-Yield Savings Account (HYSA). But what if I told you there’s another powerful tool to add to your savings stack? It’s called a Certificate of Deposit (CD), and it could be the missing piece to your financial puzzle. Not CDs that you might’ve heard of or if you’re around my age or older - you used them to play music. Heck, do you remember Columbia House? You would get 8/10 CDs for a penny. Memories and for some debt - yikes. That’s for another post.
Well, these types of CDs offer a way to safely grow your money, whether you're planning for the short term or long haul—let’s break down how they work and how you can use them to reach your savings goals!
What Is A Certificate Of Deposit (CD)?
A CD is a savings product offered by banks and credit unions that allows you to deposit a fixed amount of money for a predetermined period in exchange for a higher interest rate than a standard savings account. In essence, you’re agreeing to leave your money untouched for a specific term—usually ranging from a few months to several years—so the bank can use it for lending.
Understanding The Types Of CDs:
When it comes to Certificates of Deposit (CDs), there are a few different types you should know about. Each type has its own features and benefits, making it easier to find one that fits your savings goals, let's talk through them a bit:
Traditional CDs: These are your standard CDs, where you deposit money for a fixed term (usually anywhere from a few months to several years) at a set interest rate. You can’t access the money without a penalty until the CD matures.
Ladder CDs: This strategy involves opening multiple CDs with different maturity dates. For example, if you have $10,000, you could split it into five $2,000 CDs that mature at different times (like every year for five years). This gives you the benefit of higher interest rates on longer-term CDs while still having some cash available each year.
No-Penalty CDs: These allow you to withdraw your money before the maturity date without paying a penalty. They typically offer lower interest rates compared to traditional CDs but give you more flexibility if you think you might need access to your cash.
Brokered CDs: These are CDs offered through a brokerage firm rather than a bank. They might offer higher rates, but be aware that they can come with different rules, like early withdrawal penalties.
IRA CDs: If you’re saving for retirement, you can also find CDs specifically designed for Individual Retirement Accounts (IRAs). These work like traditional CDs but are held within an IRA.
Types Of CDs: Short-Term vs. Long-Term
Short-Term CDs
Short-term CDs generally have terms ranging from a few months to a year. They are great if you’re looking for a safe place to park your money for a brief period while earning some interest.
Tips For Short-Term CDs:
Use No-Penalty CDs: If you think you might need access to your funds sooner than expected, opt for a no-penalty CD. This gives you the flexibility to withdraw your cash without incurring penalties.
Consider Bump-Up CDs: If interest rates are on the rise, a bump-up CD could be beneficial. It allows you to increase your rate if market rates go up during your term.
Long-Term CDs:
Long-term CDs typically last for one year or more, sometimes up to five years or even longer. These are ideal for those looking to earn a stable return on money they won’t need for a while.
Tips For Long-Term CDs:
Lock In Higher Rates: If you find a CD with a good interest rate, locking it in for the long term can be a wise decision, especially if you anticipate interest rates dropping in the future.
Diversify With Laddering: To take advantage of both short and long-term gains, consider a CD ladder strategy. This involves opening multiple CDs with varying maturity dates, allowing you to access some cash sooner while still earning higher rates on longer terms.
Why Interest Rates Matter: The Impact Of Rate Cuts
Interest rates can significantly affect the Annual Percentage Yield (APY) of your CDs. If you’re following economic news or me, you may have heard about interest rate cuts being implemented by the Federal Reserve. This usually happens in response to a slowing economy, aiming to encourage spending and borrowing. When the Fed lowers rates, banks typically respond by offering lower APYs on CDs and other savings products like HYSAs and Mutual Funds.
We are noticing that the interest rates on most products are starting to fall - some for the benefit of us and some for the headache of us. We’re talking about CDs, so it’s good to put this into perspective on what to keep in mind. The returns on new CDs will decrease. If you already have a CD locked in at a higher rate, that’s great news! However, if you’re considering opening a new one, you might find that your earning potential is limited compared to what it was a couple of years ago. I usually say don’t chase the rate when it comes to a HYSA, the same I would say for CDs. You will find the APY drops faster on HYSAs than Mutual Funds and last CDs.
CDs vs. High-Yield Savings Accounts (HYSAs):
While CDs and HYSAs are both great options for growing your savings, they serve different purposes. I talked about this over on PopSugar, but let’s break down the difference here:
Access to Funds: HYSAs offer more flexibility, allowing you to deposit and withdraw money without penalty. CDs, on the other hand, require you to commit your funds for a set period.
Interest Rates: Typically, CDs offer higher interest rates than HYSAs because you’re locking your money away. However, HYSAs can adjust to changing market conditions like we’re seeing now.
Ideal Use Cases: So if you’re focused on saving but also being able to get your cash, HYSAs are your go-to, otherwise, you’re going to be locked in until your CD matures.
When you open a CD, one important thing to keep in mind is the maturity date—that’s the day your CD term ends. When it matures, you have a few options: you can take your money out (along with any interest you’ve earned), roll it over into a new CD, or move it somewhere else.
But here's where it gets tricky: many CDs come with something called auto-renewal. This means if you don’t act when your CD matures, the bank might automatically put your money into a new CD, usually with the same term. The catch? The interest rate could be higher or lower than what you started with.
Tips For Handling Maturity + Auto-Renewal:
A lot of people get CDs because they have a pretty APY, but most of them don’t know the terms of their CDs let alone the maturity date. Yikes, here’s how to handle the structure of your strategy of using them to stack your cash:
Set A Reminder: CD terms can range from a few months to several years, so it’s easy to forget when your CD is coming due. Set a reminder a few weeks before the maturity date so you have time to decide what to do with your money.
Check Current Rates: Before you let your CD auto-renew, take a quick look at current interest rates. If they’ve dropped a lot, you might want to consider moving your money to a different option, like a High-Yield Savings Account (HYSA) or a new CD with a better rate.
Know The Grace Period: Most banks offer a grace period—usually 7 to 10 days—after your CD matures. During this time, you can still make changes without penalties, even if your CD has already auto-renewed.
By keeping an eye on your CD’s maturity date and understanding auto-renewal, you can make sure your money continues to work for you in the best way possible!
Saving For The Long Haul/Term: Laddering CDs
If you have a long-term savings goal, like buying a home or funding a future investment, you can use your High-Yield Savings Account (HYSA) as a stepping stone to build a CD ladder. This is a smart way to earn more interest while still having access to some of your funds when you need them. It’s kind of like building your own “Ladder”.
Here’s How It Works:
Start With Your HYSA: First, keep your initial savings in a HYSA. This gives you flexibility and allows your money to grow while you save for your goal. Let’s say you’re saving $10,000 over a few years.
Create Your Ladder: Once you have a chunk of money saved, say $5,000, you can use that to start your CD ladder:
Open a 1-Year CD for $1,000.
Open a 2-Year CD for another $1,000.
Open a 3-Year CD for $1,000.
Open a 4-Year CD for $1,000.
Open a 5-Year CD for the last $1,000.
Reinvest As CDs Mature: As each CD matures, you can reinvest that money into a new longer-term CD. For example, when your 1-Year CD matures, you can roll it into a 5-Year CD. This keeps your money working for you while still giving you access to some cash each year.
Benefit From Higher Rates: By laddering, you’re often able to take advantage of higher interest rates for longer-term CDs while having the peace of mind that some of your cash will be available when needed.
Here’s a typical scenario in which I see some clients or commentary about savings and using a CD to structure that goal...
Scenario: Saving For A $5,000 Down Payment On A Home In 5 Years
1. Initial Situation: Already Have $5,000:
If you already have the $5,000 saved, you can directly invest in a CD. Here’s how to create a solid financial plan:
Choose the Right CD: Look for a 5-year CD with a competitive interest rate. Traditional CDs typically offer the highest rates, so you might find an attractive APY that will help your money grow over the five years. For example, if you find a CD offering 3.5% APY, your $5,000 will grow to about $5,500 by maturity.
Lock It In: Open the CD and deposit your $5,000. Remember, you won’t have access to this money until the term ends without paying a penalty, so make sure you won’t need it before then.
Plan For Interest Rate Changes: Given the current environment where interest rates may fluctuate, keep an eye on market trends. If rates rise significantly and you have a bump-up CD option, you could benefit from that if it becomes available during your term.
2. Initial Situation: Saving Towards $5,000:
If you don’t yet have the $5,000 but are planning to save towards it, here’s a step-by-step strategy:
Start with a High-Yield Savings Account (HYSA): Begin by saving your initial contributions in a HYSA. This gives you flexibility and the ability to earn interest while you save. Aim to set aside a specific amount monthly—let’s say $80—into your HYSA.
Assess Interest Rates: HYSAs usually offer competitive rates, often around 3-4% APY. Over five years, if you consistently save $80 each month, you’ll accumulate approximately $4,800, plus interest, by the end of the term.
Transition → CD: Once you reach your savings goal of $5,000 (or slightly more due to interest earned), consider moving your funds from the HYSA into a 5-year CD. You can either transfer the entire amount or wait until you hit your target, then open the CD. This can be particularly useful if you expect rates to drop or if you want the stability of a fixed return.
Keep An Eye On Your Timeline: If you’re close to your goal and rates are rising, you might want to open a no-penalty CD to earn higher interest while still maintaining access to your funds if necessary.
Example Calculation
Let’s break it down with some numbers:
Initial Deposit In HYSA:
Monthly Contribution: $80
Total Contributions Over 5 Years: $4,800
Approximate Interest (3.5% APY*): ~$200
Total after 5 Years: $5,000
Transition → CD:
Open a 5-year CD with $5,000 at 3.5% APY*.
Total at Maturity: $5,500 after 5 years.
*Look for the highest APY (interest paid as the more you save and stick it there) as possible. You can compare APYs on HYSAs and CDs on Bankrate!
Conclusion
So, it all goes back to understanding your goals. Knowing where you stand financially helps you determine which savings products work best for your pocket. Whether you’re looking to save for a down payment on a home or any other future expense, it’s crucial to understand what your money is meant to accomplish.
Hopefully, this has opened up the “book” on what CDs are and how they can fit into your financial strategy. By planning ahead and being clear about your savings goals, you can effectively combine a High-Yield Savings Account (HYSA) with CDs to reach your $5,000 down payment target.
Start saving consistently, choose the right accounts to earn the most interest, and keep an eye on interest rates to make informed decisions. This strategy not only helps you achieve your financial goals but also ensures your money is working hard for you along the way!
Stay Funded, Friends.