High-yield savings accounts are great. They allow you to set aside money in a safe place to earn a respectable return. (That return is low right now, but will increase as the economy improves and interest rates rise.) But did you know you can put your savings on steroids by using a certificate of deposit?
Certificates of deposit (often simply called CDs), by definition are time deposits. You give your money to the bank and then promise not to touch it for a specific length of time. In general, the longer you agree to let the bank keep your money, the higher the interest rate you’ll receive.
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Editor’s Note: All of the rates discussed in below article are from 2009 and do not reflect the current yields. Please see the GRS pages for savings accounts and CDs for current rates.
For example, here are the current rates from ING Direct (as of 16 November 2009):
- 6 month CD: 1.25%
- 9 month CD: 1.25%
- 12 month CD: 1.75%
- 18, 24, 30 and 36 month CDs: 1.50%
- 48 month CDs: 1.75%
- 60 month CD: 1.75%
By contrast, the ING Orange High Yield Savings Account currently yields 1.30%. Unlike a savings account, once you put your money into a CD, the interest rate does not fluctuate. If you open a 6-month CD at 1.25% and interest rates drop, you earn 1.25% the entire six months.
If certificates of deposit offer higher returns than a savings account, then why doesn’t everybody use them? The primary drawback to CDs is that they’re less liquid than a savings account; you can’t just move money in and out of them without penalty. You can take your money out of a CD before it “matures”, but you’re docked interest when you do. In fact, many (most?) banks penalize the interest amount, even if it isn’t earned (meaning you could lose part of your principle if you close your CD early).
Anatomy of a CD
I was fortunate to win a $1,000 6-month certificate of deposit from ING Direct recently. (I never win anything!) Looking at it might be instructive:
Looking at this screenshot, you can see that a certificate of deposit has an initial value (in this case, $1,000), an interest rate (3.50%), and a term (6 months). In other words, this is very much like a loan that I’m making to the bank.
You can also see that if I chose to redeem this CD early, I would sacrifice three months interest, whether earned or not. Because I’ve held the CD less than a month, if I were to break it now, I’d actually sacrifice part of my principal.
When this CD matures on April 9th, I will have $1017.28. Obviously $17.28 isn’t a huge return, but remember that interest rates are low right now. (Also consider that my $10,000 emergency fund were all in CDs, I would earn $172.80 in six months.)
Finally, it’s important to note that unlike a savings account, a certificate of deposit ends after a set amount of time. What happens at the end of the term depends on the arrangments you have (or have not) made with your bank. (See below.)
CD tips and tricks
Using a certificate of deposit is a great way to put your savings on steroids, but there are ways to make them even better. Here are a few tips and tricks that to help you get the most out of your money.
Use CDs to beat falling interest rates. When the Federal Reserve cuts short-term interest rates, you feel the pinch in your savings account. Certificates of deposit are a great way to buy yourself “protection”.
When you see a rate drop coming, open another CD. For example, the Federal Reserve just cut short-term rates another 0.50% last week. I would be shocked if banks didn’t follow suit, lowering the interest on their savings accounts. ING Direct could go as low as 2.25%.
When you see an interest drop coming, take some money from your savings account and throw it into a 6- or 12-month certificate of deposit, locking in the higher rate. (My web research hasn’t revealed what causes CD rates to move, but they do not move in lockstep with savings accounts.)
Climb the CD ladder. Just as you might use dollar-cost averaging to profit from fluctuations in the stock market, you can use a “CD ladder” to profit from fluctuations in interest rates.
Say you have $5000 to invest. To build a CD ladder, you would invest the money in CDs with staggered maturation dates:
- $1000 in a one-year CD
- $1000 in a two-year CD
- $1000 in a three-year CD
- $1000 in a four-year CD
- $1000 in a five-year CD
As each CD matures, you immediately invest your money in a new five-year CD, effectively maintaining the one-year stagger, or ladder. You won’t earn the best possible rate of return, but you will earn a good one, and your income will be relatively constant. The CD ladder is also a form of diversification: you’re not betting all your money on one interest rate. (Mrs. Micah has an introduction to laddering CDs at ING Direct.)
Protect yourself with parallel CDs. One of the biggest risks to your investment in a certificate of deposit is the need for early withdrawal. What if something happens and you need to pull the money out? As we’ve seen, this can be expensive. Nickel at Five Cent Nickel suggests mitigating your risk with parallel certificates of deposit.
Again, assume have $5,000 that you’d like to put into CDs. Instead of opening a single certificate of deposit for the full amount, consider opening multiple CDs. You might open three CDs at once, for example: two $1,000 CDs and one $3,000 CD.
This gives you a buffer in case you need to get at the money early. If you find you need $500, you can break a single $1,000 CD and the rest of your money is safe from penalty.
Beware auto-renewals. Nicole wrote last week because she was surprised to find that her certificate of deposit at Countrywide had automatically renewed at the maturation date. Many (most?) banks will do this unless you instruct them not to.
If you know you’re ready to pull your money out of a certificate of deposit, be sure to contact your bank to find out the proper procedure for doing so. Nicole found herself locked into another twelve month CD when she needed the money now. If she broke the contract, she would be forced to sacrifice 180 days interest, whether earned or not.
(Note that Nicole’s story had a semi-happy resolution. She knows to speak up when something seems wrong. Countrywide wouldn’t let her out of the CD entirely, but “I was able to negotiate a compromise to transfer the money to a 3-month CD, rather than the 12 month CD. Although the interest rate is lower, I will be out in 3 months, which isn’t too bad.”)
Shop around. As with any financial decision, it pays to shop around for CD rates. You may find that your local bank actually offers a better deal on certificates of deposit than the online banks.
For example, my local credit union only offers 0.35% on its regular savings account, but its CD rates are competitive with (and sometimes higher than) ING Direct. Since I keep my checking account at the credit union, it might make sense for me to hold my CDs there. (In this case, however, they’re not high enough to make me switch; I’d rather track everything in one place at ING.)
Here’s my list of current CD rates from online banks.
CDs in practice
I’m new to the certificate of deposit, but I can already see some uses for it. My $10,000 emergency fund, for example, is currently earning 2.75%. I may instead create a series of parallel CDs, as described above.
Also, I’m saving for my Mini Cooper. That money is also earning 2.75%. I’m nowhere close to buying the car, though, so I might as well put it into a certificate of deposit, too.
Though certificates of deposit are new to me, I’m sure that most of you have been using them for years. What tips and tricks can you offer? Do you have favorite sources for CDs? How do you decide which money to keep there and which to keep in a savings account?
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