The Certificate of Deposit (CD) is the most basic and mundane investment vehicle offered by banking institutions. If you agree to hand over your money to the bank for a specific period of time they will reward you with a higher interest rate than your savings account. In a regular savings account the bank has no guarantee that you won’t just withdraw all the money the next day. As an example, Citibank (C) currently offers 0.7% APY for day-to-day savings account and 5% APY for a 6-month CD.
The amount of interest on your deposit depends on how long you hand over your money to the bank. The general trend is that the interest is higher the longer you keep your money in the bank. This is because the bank can do more with your money during a longer period of time; like investing it or loaning it out to people. In this example, the rate goes down after 6 months because the bank expects the Federal Reserve to lower interest rates in the future. If the bank can get cheaper money in the future, then it is unlikely to give you a better interest rate for longer-term CDs.
People often ladder CDs to lower the commitment of their funds. Laddering eases the commitment by having multiple CDs mature at different times. Each time a CD matures it is like a rung on the ladder. If I had $10k in a one year CD, my money would be locked up for a year. If I put $2.5k in a one year CD in January, April, July, and October I would have $10k in CDs for a 1 year term, but every 3 months I can take $2.5k out and spend it as I wish or reinvest it. This keeps your money from being locked up.
- Higher returns than savings accounts
- Guaranteed return for a period of time
- FDIC insured up to $100,000
- Easy to transfer money from existing savings/checking at the same bank
- Returns typically lower than stocks and bonds
- Penalties for early withdrawal of funds from a CD.
- Some banks require high minimum balance
Online banks offer savings account with interest rates close to CDs, such as 4.5% on HSBCDirect (HBC). While investing in a S&P500 index fund will most likely yield 10% over the long run, CDs still have their place if you plan to use that money in a year but don’t want as much risk. If you’re planning to buy a car in a year, then a CD is a good place to put your money.