When shopping for CDs, it pays to be aware of the current interest rate environment and the offerings available.
As the Federal Reserve continues its rate-raising campaign, CD rates should continue to rise. You can still take advantage of current CD yields while giving yourself the flexibility to earn higher yields in the future – if you use the right strategy.
Follow these top 10 CD strategies to make the best investment.
1. Determine what the money is for
What are you saving for? Figuring this out will help you evaluate the time horizon for the money. If the funds are likely to be used within the next month or next few months, a savings account or money market account is probably a better option than a CD.
“The first thing that we do is think about when money might be used, or if it’s earmarked for a specific goal,” says Lauren Zangardi Haynes, CIMA, certified financial planner at Spark Financial Advisors.
One smart reason to save in a fixed-rate CD: You’ll know exactly how much money you’ll earn during the term. CDs are also smart investments if you don’t want to lose your principal amount. CDs provide safety in the form of principal protection and Federal Deposit Insurance Corp. (FDIC) coverage.
If you plan on needing your money before the CD term would end, a CD isn’t the best place for those funds. If you have to withdraw your money early, you may be hit with an early withdrawal penalty, which may negate your interest earnings or even cut into your principal.
Also, if you’re trying to grow your money more aggressively, other types of investment products would be a better fit. Products like stocks, mutual funds, exchange-traded funds or other investments may offer higher gains. But they also have the potential to lose principal.
2. Figure out when you’ll need the money
Determining when you’ll need the money will help you avoid early withdrawal fees. While emergencies happen, you should have an idea of when this money will be needed. That will help you determine how long of a CD term should be taken out.
If you want to buy a house in a couple of years, a CD would be a good investment because you would protect principal and earn a competitive annual percentage yield (APY).
“We don’t necessarily want to take on a lot of risk by investing it, but we’d like to earn a little more interest,” Zangardi Haynes says.
If the money is for your emergency fund, part of the money can go in a high-yield savings or a money market account, and then a portion can go in a CD to get a higher APY. This will ensure that you have funds in place for your everyday transactions and for unexpected instances.
Money that you won’t need for at least five years will likely earn a higher yield in the stock market.
3. Choose an online bank
If you’re looking for the highest APY, a direct bank is probably the place to look. If you want to sit down with a representative and talk about options, then the traditional brick-and-mortar bank might be the place to go, but the APY will likely be lower.
Online banks tend to offer higher yields and lower fees. That’s because they don’t carry the same overhead costs compared with walk-in branches, and they can pass on that savings to customers.
For example, Sallie Mae Bank, an online bank, offers a 2.65 percent APY on its 1-year CDs – almost four times the national average of 0.72 percent APY. On the other hand, Chase’s highest 1-year CD yield is 0.05 percent APY – more than 14 times below the national average.
You can compare CD rates on Bankrate to see which banks offer the highest yields.
4. Be aware of (and avoid) fees
When shopping for a CD, find out the early withdrawal penalty. While you should be purchasing a CD only if you’re confident that you won’t be touching the money before it matures, it’s good to know what the worst-case scenario will be ahead of time.
A penalty of 90 days’ worth of simple interest is a common early withdrawal fee on a 1-year CD, though some banks have penalties of six months’ worth of simple interest. Other banks may have even steeper penalties or may penalize based on a percentage of the withdrawal.
5. Know how often the CD compounds
Find out how often the CD compounds interest and factor this into your purchasing decision. The more often the CD compounds, the better. Always try and find CDs that compound daily.
Daily compounding is the most common, but some banks may compound monthly or even more infrequently. Compounding is when interest is paid on principal and on the interest that’s already accumulated.
6. Go short term
While interest rates are increasing, going for the shortest term with the highest APY is a good strategy. Weighing the benefit of the APY against the next longest CD term – and how much you think CD rates will increase – will help you determine how long to lock your money in for.
Remember, if your choice is between a CD and a savings account – and the APY is the same – go with the savings account because it offers liquidity and full access to your money at any time. Go with the CD if you’re being rewarded with a higher APY for the term and won’t be touching these funds during the CD’s term.
7. Ladder your CDs
A CD ladder is when you open multiple CDs maturing at different intervals to take advantage of higher interest rates. CD laddering lets you earn the higher yields offered on those longer-term CDs while still having cash in hand as the shorter-term CDs mature.
For example, you could open three CDs – a 1-year CD, 2-year CD and a 3-year CD. This strategy gives you the flexibility to avoid early withdrawal fees if you need money sooner than expected. It also helps you to diversify your CD portfolio – assuming the longer-term CDs are currently earning a higher APY.
In a rising rate environment, a CD ladder may be good strategy for some customers, says Crystal Rau, certified financial planner at Beyond Balanced Financial Planning.
“You get to take advantage of the short term one’s maturing and reinvesting those at higher rates if they do increase,” Rau says. “However if they don’t, then you have those longer-term ones – and they’re getting the better rate.”
8. Consider the indexed, or structured, CD
One nontraditional CD is the structured CD, which is linked to some other type of investment, such as the stock market, currency market or commodities. Though they won’t lose money as long as they are held to maturity, returns are typically capped at a percentage of the total return of the underlying index or basket of securities.
For example, if it’s linked to the Standard & Poor’s 500 index, and that index returns 10 percent over the year, a structured CD may yield three-quarters of that. However, it varies among products. That is one of the criticisms of structured CDs: They can be very complex compared with a conventional CD.
But the potential for greater returns pulls in savers. There are more downsides, though, the most visible of which can be the statement showing the value of the investment dropping from year to year.
The drop in value isn’t necessarily a result of volatility in the underlying investments, but because of the limited demand for these kinds of CDs on the secondary market.
9. Look at bump-up CDs
Some types of CDs are better suited for low-rate environments than others — for example, the bump-up.
If interest rates go up, a bump-up CD allows the owner to seek a CD rate increase. With interest rates possibly rising again before the end of 2018, longer-term bump-up CDs would seem to be just the ticket for savers concerned about chasing yield and interest rate risk.
Rates on bump-up CDs are typically competitive with traditional CDs but are less than a special promotional rate.
10. Consider a barbell strategy
A barbell is another CD investing strategy. It’s very similar to a ladder, but the middle rungs are missing. Short maturities make up one end of the barbell, or investors may even put money in a high-yield savings account to keep part of the principal more liquid. Long-term maturities make up the other end of the barbell.
If you’re looking at a longer-term CD, weigh the potential increase in APY with the potential early withdrawal penalty, says Amy Hubble, PhD, CFA, certified financial planner at Radix Financial LLC.
“You can usually get the most value by going ahead and do the longest-term CD that they offer, which is usually five years,” Hubble says.