For people of all ages who want a low-risk investment, Certificates of deposit (CD) make sense financially. They allow you to park cash you are not planning to use immediately.
Perhaps, shortly you want to use your cash to purchase a car or maybe you are looking for a down payment on a house soon, then a CD might not be the best choice. However, if you will not require your cash reserve this week or next week, you probably would like to see your money earn a better rate of return than what your checking account can offer, without a lot of risks. A certificate of deposit is a useful option.
There are 2 factors you need to think about when you are trying to determine if a CD is a right investment for you:
The predictable direction of interest rates helps you to decide how long you should tie up your money. If the interest rates are increasing, (typically when inflation is on the rise), then a short-term CD might be the best option for you. If the rates are falling (typically when the economy is on a downswing), then investing in a longer-term CD might be the best way for you to earn more money, since you will be locked in at a higher rate.
Your time horizon
When are you going to need part/all of your cash? If you were in a pinch, do you have other cash resources you can access? If you have a sum of money and you do not think you will need to use it for at least six months or longer, then a CD may be ideal.
How to invest
Prior to starting to shop around for a CD, there are two numbers you need to be aware of:
APR – The annual percentage rate, or the interest rate a bank is offering on the CD.
APY – The annual percentage yield, which tells you what you will earn over the multi-year life of the CD as your money compounds.
What is compounding?
It is how your investment will grow over a period of time. For example, you invest $10,000 in a three-year CD earning 6 percent annually. In the first year, your $10,000 investment will earn $600. In year two, 6 percent of the new total ($10,600) will be $636 ($11,236). In year three, 6 percent of $11,626 will be about $674 for a final total of $12,300. The total amount of money will grow annually, so the amount that represents 6 percent of your investment also grows. This is what compounding is.
If you have concluded that Certificate of Deposit is the perfect investment for your cash. Here is what you need to do next:
Choose your term
Decide how long you want to keep your money tied up for. This depends on when you will need your money or whether you have additional cash assets you can use to hold you over until your Certificate of Deposit matures.
Pick your type
You will need to determine which type of CD best suits you. For example, maybe you want to invest for 3-years but you do not want the risk of being saddled with a low rate, then you might want a bump-up CD. Another example – perhaps you are worried you will not have access as you need part of your deposit for an emergency. Then consider a liquid CD.
Review the rates
Once you have chosen the type of CD and the duration you want, it is time to find out what rates the different banks have available.
Consider a ladder
One way that you can decrease the drawbacks of a CD is by using a technique that is called “laddering”. With this strategy, you have regular access to part of your cash while at the same time you are protected against interest rates rising.
Laddering is simple. Rather than investing one big chunk of your money in one CD, you divide your money into equal parts and then each amount is invested in CDs of various durations.
This is how it works: Let’s say you have $15,000 to invest. If you were to use laddering, you would invest $5,000 in a 1-year CD, then $5,000 in a 2-year CD and then the last $5,000 in a 3-year CD. Every time one of the three CDs matures, you have the choice of taking your cash or reinvesting it in another 3-year CD keeping your ladder in place.
Laddering provides 3 benefits:
- Because you are always investing in a longer-term CD you will get the most favorable interest rates.
- You have penalty-free access to cash every time a CD matures.
- You have an opportunity to higher returns if the interest rates are higher at the time of reinvesting.
Certificates of Deposit are made for those who are planning to park cash and don’t need to use it immediately. If you have a sum of money and you do not think you will need to use it for at least six months or longer, then a CD may be the ideal way to earn some extra money. Choose your term, pick your type, then review the rates, and start earning! Also, use “laddering” technique to decrease the drawbacks of the CD.