Savers, get excited.
The Federal Reserve just raised interest rates for the fourth time this year. That’s good news for savers, and it’s a relief for investors looking for ways to bump up their returns without taking on more risk than they can sleep with at night.
But, should you buy a CD when rates are expected to rise? The answer to that question depends on more than the current rates climate.
You also should consider your personal financial objectives, time horizon and risk tolerance, says Dana Twight, founder and principal of Twight Financial Education in Seattle.
Try a short ladder of CDs
If your main objective is to add to your wealth over a long time horizon and you want to plan for higher rates, “the conventional wisdom is to shorten your maturities,” Twight says.
That might mean buying a so-called ladder of CDs with varying maturities measured in months rather than years. If rates rise, this ladder could allow you to roll over your funds at higher rates as your CDs mature. If rates don’t rise, you’ll have sacrificed the higher return you might have received with longer maturities. A CD ladder calculator can help you maximize your returns.
Either way, Twight says, investors need to lower their expectations, understanding that a slightly better return for an online bank CD instead of that for a money market account makes a substantial difference.
“If you ratchet those expectations down, half a percent increase is pretty darn exciting,” Twight says.
One way to attempt to improve your return is to direct the interest from your CDs to a mutual fund instead of spending or re-depositing it.
As Twight says, “This strategy preserves the principal and allows unneeded income to go into the stock market periodically and automatically.”
When to consider laddering CDs with longer maturities
If your main financial objective is to protect wealth you’ve accumulated, yet you’re sorely tempted to dip into your principal, a ladder of CDs with longer maturities might be helpful if only for psychological reasons.
“The CD strategy works for people who want preservation of capital and really, really, really want to make it a little harder to get to,” Twight says.
The risk is that if rates rise, you’ll have to pay a penalty to break out of your CDs or you’ll miss out on the chance to capture those higher returns. If you have a long time horizon for wealth preservation, CDs with long maturities might be too conservative as an investing strategy because of the effect of inflation.
There are some exceptions. Marcus by Goldman Sachs, for instance, announced in November a CD that lets customers withdraw their balance beginning seven days after opening the account — without any penalty. It’s not alone in offering no-penalty CDs either. However, some of these products require you to close out the entire account, rather than take out a portion of the money parked there.
Also remember, if you have a long time horizon for wealth preservation, CDs with long maturities might be too conservative as an investing strategy because of the effect of inflation.
“If you retired at 45, 55 or 65, you could need that money for another 30 years,” Twight says. “Because of that time horizon, you may need to be more aggressive.”
One tactic to attempt to boost your return is to invest in mutual funds and stash your capital gains in bank CDs.
Regardless of your objectives, you should think of your CDs in a relative, rather than absolute way.
“Every type of investment has a role it can play in a portfolio,” says Joseph Heider, financial adviser and president of Cleveland-based Cirrus Wealth Management.
So, avoid making decisions about a CD or any other one part of your portfolio without weighing its place in your whole financial picture.
Predicting interest rates is mission impossible
Perhaps the biggest potential pitfall for CD savers is trying to predict interest rates and making investment decisions based on those predictions. Because no one can predict the future — not even when the Fed’s market signals seem clear.
Cheryl Krueger, president of Growing Fortunes Financial Partners in Schaumburg, Illinois, explains: “The same way that I don’t try to time the stock market, I don’t try to time interest rates.”
It pays to shop around for the best CDs
David Rae, president and founder of Los Angeles-based DRM Wealth Management, advises savers to look around for CDs and compare different banks’ rates for desired maturities. “It does pay to shop around,” Rae says.
In particular, he suggests taking a look at online-only banks. Without the fixed cost of physical branches, online-only banks tend to pay higher rates. Also, keep your eyes open for financial institutions that may offer teaser rates for new customers.
But remember, you’ll be swapping your time for something that may have only a small payoff if you’re buying CDs from multiple banks. “Be aware of the hassle factor of opening too many accounts,” Rae says.
If you decide to shop for so-called brokered CDs, which are sold through investment advisers or stock brokerages, ask about and compare fees you may be charged as well as rates you’ll be offered.
Lastly, you may want to consider a bump-up CD from banks and credit unions in a rising rate environment. Bump-up CDs give account holders the option to raise their annual percentage yield at least once before the end of their term, upon request.
“It gives you a little flexibility so you’re not tied in at one rate,” Rae says.
So when rates rise, just remember these three things:
- Shop around. You want to get the best rate.
- Most likely, invest in short-term CDs for the added flexibility to reinvest.
- Remember: No one can predict when the Fed will hike interest rates.