The Federal Reserve has raised its benchmark interest rate six times in the last three years. That’s good news for savers who have waited—and perhaps prayed—for higher yields. 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.
Now that the Fed is raising rates, should you buy a CD? The answer to that questions 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.
When to ladder CDs with shorter maturities
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,” she 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.”
Laddering CDs with longer maturities
If your main financial objective is to protect wealth you’ve accumulated, a ladder of CDs with longer maturities might be helpful, in part for psychological reasons.
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, in part 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 due to 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. Don’t make decisions about a CD or any other one part of your portfolio without weighing its place in your whole financial picture. If you need help making investment decisions, consider finding a financial adviser in your area.
Never try to ‘time’ interest rates
Perhaps the biggest potential pitfall for CD savers is trying to predict interest rates and making investment decisions based on those predictions. Because the fact is no one can predict the future—not even when the Fed’s market signals seem clear as the proverbial crystal.
Because the fact is that no one can predict the future — not even when the Fed’s market signals seem clear as the proverbial crystal.
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.”
What’s more, a rate hike by the Fed might not translate into higher rates for CDs or other bank deposits as long as rates are near zero or even negative in some other countries, says Ronald D. Weiner, managing director of RDM Financial Group at HighTower in Boca Raton, Florida.
Shop around for the best CD rates
Weiner advises savers to shop around for CDs and compare different banks’ rates for desired maturities.
“Some banks may offer better short-term, others better long-term,” he says.
Rather than buy your entire CD ladder from one bank, you might want to buy CDs from multiple banks, mixing and matching the highest rates you can find for different maturities.
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.