What first-time CD investors face
Whether you’re just setting out on your path to saving or are nearing retirement, a bank certificate of deposit, or CD, can give you a fixed interest rate typically higher than that of a traditional savings account or money market account. From three months to five years, the wide range of terms for bank certificates of deposit gives you plenty of options.
High interest rates and Federal Deposit Insurance Corp. insurance are obviously important when searching for a new CD, but you need to consider other crucial factors.
As you begin your search, remember these six tips.
Know your own finances
Don Taylor, assistant professor of business administration at Penn State Brandywine in Media, Pa., and Bankrate’s investing adviser, advises consumers to consider three factors when looking for a new home for their money — liquidity, yield and convenience.
For an investor with a smaller amount of capital to invest in CDs, Taylor recommends answering one question: Do you have liquidity concerns?
If unexpected financial challenges force you to withdraw your funds early, Bankrate’s 2010 early withdrawal study shows that banks can hit you with hefty fees. In fact, 92 percent of banks in the study will take funds from your principal deposit to cover fees, if necessary.
Not sure how much easily accessible cash you need? Use Bankrate’s emergency savings calculator to make sure your savings stash is strong enough before you buy a new certificate of deposit.
Shop around for the best rate
Because a certificate of deposit only requires an initial deposit, traditional banking tools such as ATM access and in-person banking are nonessential. Banks that conduct most, if not all, transactions via online and telephone transactions often offer CDs with bigger yields than banks with a large network of retail branches.
Steve Olszewski, vice president of deposit products at Discover Bank, says a bank’s lack of brick-and-mortar branches gives the institution a cost advantage, and it can reward its customers with increased interest rates.
For example, while today’s national average for a one-year CD is 0.49 percent, Discover and other online banks currently offer rates 1.3 percent or better for the same CD.
Be sure to compare CD rates at online banking institutions as you start your search.
The truth is in the APY
The interest rate does not tell the whole story.
Instead, a CD’s annual percentage yield, or APY, paints the full picture of your expected return. The Truth in Savings Act requires that all banks use a standard formula to calculate their advertised APYs. This formula takes the CD’s compounding rate into account to deliver an exact calculation of how much money a CD will help you earn annually.
For example, if a five-year CD carries an interest rate of 2.46 percent, an investor’s return — the APY — will be slightly higher annually at 2.49 percent because the interest is compounded daily.
To better understand the difference between compounding daily versus monthly or quarterly and how it affects your APY, use Bankrate’s compound interest calculator.
Understand early-interest withdrawal
Investigate your early-interest options. Depending on your age and the goals you have for your new CD, access to interest as it accumulates can help provide you with additional money before it matures.
For example, some of Discover’s CD account holders who are approaching retirement use interest from a CD as a source of income, Olszewski says. The bank allows customers to designate a Discover online savings account or an outside account within the interbank clearinghouse network for access to monthly transfers of accrued CD interest.
However, this privilege does come with a price. While access to interest provides you with another stream of income, Taylor says that removing this money will lower your APY. When interest is withdrawn, it does not receive the benefit of the compounding rate.
Simply put, the more money you keep in your CD, the more money you can earn.
Don’t be afraid of commitment
You can avoid intimidating early withdrawal penalties. Some banks such as TD Bank offer penalty-free CDs that give customers options to withdraw their funds or take advantage of higher interest rates prior to maturity without additional fees.
“In this environment, customers want their funds as liquid as possible,” says Ryan Bailey, senior vice president at TD Bank.
Beth Coggins, spokeswoman for Ally Bank, sees the same trend among Ally’s customers who are considering the bank’s No-Penalty CD and Raise-Your-Rate CD.
“These products may appeal to customers who want the safety and competitive rates of a CD, but are concerned that they may need to access the money or want options if rates should rise,” Coggin says.
While liquidity offers a certain degree of comfort, these penalty-free programs usually mean lower interest returns, says Greg McBride, CFA, Bankrate senior financial analyst.
“Investors need to ask themselves one question: Is the yield you forfeit on the front end more than what you would recoup if you remove it prior to maturity?” McBride says.
As you weigh your options, be sure to list the pros and cons of having more convenient access to your money.
Climb your way to bigger CD earnings
The longer you’re willing to commit your money to a CD, the more handsomely you’ll be rewarded. One commonly used technique to increase a return is laddering.
“A ladder is a way to diversify your money among a range of maturity dates, and it’s an all-weather strategy,” McBride says. “It’s not a way to time the interest cycles.”
A ladder spreads your money among a range of CDs with different terms and APYs. Despite the current low CD rates, a ladder can help you maximize your return.
In the current climate, Taylor recommends starting with a stepladder. Also known as an extension ladder, it begins with shorter terms with the ability to move into longer maturities in the future.
“If you build your ladder all at once, you’re investing in the current rate environment,” Taylor says. “A stepladder gets you around that timing issue, when you’re building that ladder.”
McBride agrees, advising that now is not a good time to lock in longer maturities. As the market improves, your ladder can extend to take advantage of increased interest rates.
Use Bankrate’s CD laddering calculator to understand its impact on your return.