Beginner Guide to Certificates of Deposit
CDs, otherwise known as certificates of deposit, are a variable length guaranteed investment vehicle. When you buy a CD, your money is tied up for a fixed period of time. In exchange for this, the seller of the CD, usually a bank, agrees to pay you a certain interest rate over that period. You are able to take your money out before the agreed period is up, but if that happens no interest is owed. You only make money with CDs if you hold it for the entire term length. CDs of varying time periods are offered by various banks, ranging from 3 months up to over a decade. Typically, the longer the period of a CD, the higher the rate of return.
How Does a Certificate of Deposit Work?
To see how certificates of deposit work in practice, let’s consider putting $100 into two different CDs. One is a 6 month CD paying out a 2% APY, and the other is a 3 year CD paying a 3% APY. In the first case over the first six months our $100 would earn $10 in interest, or half of 2% for half of the year. If we allowed that six month CD to continually rollover (excluding reinvesting gains), over 3 years it would have earned $60.Our second CD paid out a slightly higher rate, earning $30 each year over those 3 years for a total of $90. Looking at this your immediate thought may be that the 3 year CD must be better, but it really depends on your needs. Buying the 3 year CD means trading a longer period of not having the ability to access your money and use it for other things for a slightly higher interest rate. You make more overall, but by using a shorter CD and allowing it to roll over continuously you maintain greater access to your money.
Long story short, if you can be sure that you will not want to touch money for a certain period of time, a lengthy CD period makes sense. On the other hand, if you think you may need that money at some point, whether it’s for a large purchase or as an emergency fund, it often makes more sense to invest it into shorter term CDs which rollover as they mature.
CD Ladders
One investment strategy that helps make money in a CD more accessible to withdraw is to build up what is known as a CD ladder. The idea behind a CD ladder is that rather than putting a lump sum into a CD all at once, you can put a fraction of that sum in every day over the length of the CD.If you have $10,000 to put into a 3 month CD, but want to be able to more easily access portions of this money, you could put 1/90th of the amount into a 3 month CD every day. By the end of the first three months you will have 90 different 3 month CDs, each of which will mature on a different day over that period. They will each automatically rollover every three months, and on any given day you would be able to immediately access a fraction of the total without losing out on any interest income.
This strategy can be used with different intervals and ratios as well; it all depends on how often you want to have opportunities to withdraw money. It is uncommon for individual investors to partition a CD ladder that heavily; it may make more sense to split the CD ladder into thirds, depositing a portion each month. Think about how much money you want to be easily accessible, and how often you may want to access that money, and make a decision from there.
Warren Buffet, famed investor and billionaire chief executive of Berkshire Hathaway, has built up Berkshire Hathaway’s cash pile to over $100 billion. In addition to holding large amounts for insurance payouts, he wants to have that money available to rapidly deploy in the event of a large-scale economic crisis. In order to have this massive pile of cash earning interest but always at the ready, Buffett utilizes a 28-day CD ladder. Being a large-scale investor, Buffett has interest rates available to him that the rest of us can only dream of. Such a short-term CD would offer paltry rates to the average individual investor.
Are CDs Worth It/Is a CD Right For Me?
There are several things to consider when you’re thinking about whether or not to invest in a CD. You mainly want to think about the rate available as well as the term length imposed. If you are investing money that you plan on not touching for several years, getting a longer term CD makes sense. If you want to keep your money more accessible, a CD or CD ladder with terms less than a year is probably better.One of the great things that CDs offer is safety. You cannot default on a CD or end up losing any part of your principal, or initial investment. However, there are other safe investment vehicles as well, and some of them offer rates comparable to CDs.
I personally have never invested in CDs because I have always been able to find high yield savings accounts (sometimes called money market accounts), another guaranteed investment vehicle which offers rates that rival even 3-5 year CDs. High yield savings are normal savings accounts which offer APYs similar to CDs. The advantage of a high yield savings over a CD is that you can withdraw all or a portion of your money at any time and you will simply stop earning interest on what you withdraw.
On the other end of the spectrum, if I knew I could invest some money for a minimum of five years, I would likely put it into the stock market rather than a long term CD. Although slightly riskier, the stock market offers much better potential returns and is less risky if you have a long term time horizon. But be warned, you should never put money into stocks that you would not be okay losing. This is the guiding principle behind all of my personal stock purchases.
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