CDs, I think, have dropped in popularity over recent years, but they do serve a purpose.
In this post, we are going to explain what a CD is, the different types of CDs, their characteristics, and when they are most commonly used.
What is it?
CD is short for
Additionally, your money earns interest while in the account. However, if you withdraw the money early, you will be penalized. The penalty varies depending on the term length of the CD, meaning the longer the term of your CD, the higher the penalty.
Another characteristic of a CD is most of them require a minimum amount, with $500 being the lowest minimum. I did find, however, that the vast majority of online banks have no minimum deposit requirement.
The interest rate on a CD depends on two things:
- The prime rate - which is the interest rate the Federal Reserve charges member banks to borrow money. This rate affects all other rates.
- The length of the CD - The longer the term for a CD, the higher the interest rate. CDs can have term lengths of 5 years or more, and rates can rise or fall by quite a bit during that period. This comes as a risk to the depositor, who, in turn, needs to be compensated for that risk.
What are the interest rates right now compared to other points in time?
We’ll use a 1-year CD for this comparison.
- 1985 - 8%
- 1990 - 8%
- 1995 - 5.5%
- 2000 - 5%
- 2005 - 2.5%
- 2010 - .75%
- 2015 - .25%
- 2019 - 2.75%
What are the different types of CDs?
- IRA CD - An IRA where all of the money is invested in a CD.
- Jumbo CD - A CD with a minimum deposit requirement of $100,000
- Bump-up CD - A CD where the depositor has the ability to take advantage of rising interest rates. They have a one-time option to bump up their rate.
- Step-up CD - A CD with an interest rate the increases at regular intervals.
- Liquid CDs - A CD where you have the flexibility to withdraw your money early, but at the penalty of a lower interest rate.
- Brokered CDs - A CD purchased through a broker.
If you'd like help deciding which CD is best for you, give this article by Bankrate a read.
How does one decide the term length?
Term length with regard to certificates of deposit has to do with two things.
- How long can you afford to tie up money for?
- What financial obligations do you have coming up?
If you have a decent amount set aside for emergencies, at least a few months worth of expenses, then a CD could be an appropriate place to park some money.
The other thing to consider is if you have anticipated expenses in the near future. For example, a down payment on a house. If you have a few months to a few years, want your money to earn a little interest, but don’t want to risk it in the stock market, then a CD might not be a bad idea.
Over the long-term, however, say 10+ years, it’s not recommended. You’ll fare much better investing in the stock market.
Besides, inflation would eat into your principal. At the very best, you’d make enough in interest to keep pace with inflation. That means your money in the near future would be worth just as much as it’s worth now.
What’s a CD ladder?
A CD ladder is when you deposit funds in a series of CDs with increasingly longer term lengths. For example, if you had $20,000, you could invest $5,000 for 3 months, $5,000 for 6 months, $5,000 for 9 months, and the last $5,000 for one year.
This gives you the ability to plan ahead without having to tie your money up for long periods of time.
CDs can be an effective way to financially plan for the short-term. If you have a good chunk in emergency savings and anticipated expenses due in the near-term, but far enough away that you’d like to earn some interest in the meantime, then a CD is for you.
If you’d like to learn more about CDs and how to use them effectively, send me an email or join our newsletter!