Answers to 4 Common Questions About Certificates of Deposit

If your investment appetite skews more toward safe and predictable than risky and aggressive, don’t overlook certificates of deposit. These accounts may not be flashy, but they offer steady returns over time.

CDs, as they’re known, are usually among a bank’s bread-and-butter offerings, which may explain why some customers gloss over them. But these term-limited savings accounts have some very appealing attributes hiding in plain sight. 

Originally known as time deposits or certificates, CDs are rooted in early European banking practices dating back to the 1600s. Banks would issue receipts to depositors that stipulated the interest rate to be paid over a set amount of time. CDs offered customers an incentive to keep their money in banks longer and gave banks more capital to lend.

Modern CDs rose to popularity in the 1960s after U.S. banks struggled with a significant deposit shortage in the 1950s. As market rates rose, businesses and individuals looking for higher-yielding investments moved their money out of checking accounts and into Treasury bills and securities. Banks countered by offering CDs, and they’ve been around ever since. 

CDs remain a viable investment tool, although half of Americans surveyed in 2019 weren’t entirely clear how they worked—and 30% had “no idea” what CDs were. Read on for a crystal-clear explanation and answers to some common questions about certificates of deposit.

1. How do certificates of deposit work?

Some of the confusion surrounding CDs may just be semantics. CDs are essentially savings accounts, but their name is a bit of a misnomer.

Simply put, a CD is a savings account with a fixed interest rate and maturity date. CDs typically offer better rates of return than traditional savings accounts but impose hefty penalties if you withdraw money early.

Both CDs and saving accounts are opened with a bank deposit, but the minimum deposit for CDs is much larger. And while you can continually make deposits—and should—into your savings account, you can’t add to your CD. That is why it’s important to determine on the front end how much you can realistically afford to set aside in a CD.

The duration of CDs and interest rates—known as the annual percentage yield, or APY—vary widely from bank to bank, with terms ranging from just three months to as much as 10 years. Usually, the longer the term, the higher the rate.

Leaving your CD untouched comes with a reward. Most banks will pay out the accrued interest as a check or allow you to deposit it another in-house account. For example, if you deposited $5,000 in a five-year CD at a 0.75% APY, you’d earn almost $200 at the maturity date. Use a CD calculator to figure out what you could earn over time.

2. Are CDs worth it?

CDs are absolutely worth it for the right type of investor—one who has plenty of money to sock away and likes the idea of predictable, albeit modest, investment earnings. 

A surplus of money sitting in a no-interest checking account or a low-interest savings account is likely better off in a CD. Investors who are financially secure but don’t want to play the stock-market odds with their savings should take a serious look at CDs.

The state of the economy is another factor to consider. Can you afford to have money tied up in CDs if you lose your livelihood and need access to emergency funds? A bullish outlook certainly makes CDs more attractive. 

Setting aside a certain portion of your savings and then divvying it up among CDs with attractive rates can create a nice, low-risk multiplier effect. As maturity dates near, you can start shopping around for the best interest rates and keep reinvesting the money.

3. When is a CD a good investment?

As we’ve covered, CDs are a good investment in the traditional sense that you know exactly what you’re getting. You don’t have to worry about market forces outside your control, and you can set a clear financial goal and gradually work toward it. 

So when is it a good time to invest in CDs? Well, the ideal candidate is in a low tax bracket, has more than a few thousand dollars to invest and won’t miss the cash while it’s sitting in a CD earning interest. 

On the topic of interest, don’t just compare rates against each other but look at inflation. If the rate of return isn’t higher than inflation during the CD’s term, you’re actually losing money. That’s where a good CD investment strategy is your best friend. Here are three tacks to try when investing in CDs:

  • Ladder – This strategy consists of investing in a mix of short-term and long-term CDs to take advantage of the highest rates. By staggering maturity dates, you ensure that you’re rotating money through CDs and reinvesting if rates are favorable. 
  • Bullet – The goal with this strategy is to have all of your money available at a certain point in the future. For example, you might be working toward a down payment on a home or retirement nest egg. With that in mind, you might invest in a variety of CDs, with maturity periods of one month to six years that all mature around the same time. 
  • Barbell – This approach focuses on balancing short-term CDs and long-term CD rates to achieve a medium-rate yield. On one end of the figurative barbell you have short-term CDs maturing at a faster rate and keeping your cash from being tied up too long. Long-term CDs with higher rates anchor the other end. 

4. What is a good CD rate?

Certificate of deposit rates are changing all the time and depend largely on the financial institution, length and amount of deposit and federal funds rate set by the U.S. Federal Reserve. When the Fed raises rates, banks offer higher APYs on CDs—and vice versa.

The CD rate forecast for 2021 suggests that rates will likely remain low in the near term but could improve later in the year, depending on the success of economic recovery efforts. The Federal Deposit Insurance Corp. tracks weekly average CD rates for deposits of less than $100,000 and of $100,000 or more. A good rule of thumb is to invest in CDs offering higher-than-average rates.

Community Point Bank offers attractive and competitive interest rates on CDs from zero to 30 days to six years. Contact us today to learn more about diversifying your portfolio with certificates of deposit and taking advantage of these practical investment savings tools.