Financial gurus on the internet and TV rarely mention Certificates of Deposit as an investment choice, mostly because they aren't sexy. They won't make you a ton of money overnight, and they aren't exotic.
But they can be a valuable part of a diversified investment strategy.
What Is a Certificate of Deposit and Why Do Big Investors Hate Them?
A Certificate of Deposit (CD) is a medium-term investment you usually purchase from a bank or credit union. You are committed to keeping the money invested for a set length of time, and you may face an earnings penalty if you withdraw it before then. This means that if you take the money out before the specified date, you could lose a portion of the interest you would have gotten. CDs are similar to savings accounts in that they are insured "money in the bank" and thus virtually risk-free.
Investment gurus tend to scoff at CDs because they usually earn less than stocks and money market funds do. Also, (spoiler alert) many of these investment gurus get paid to sell you their investment products.
CDs usually pay more interest if you buy them for a longer term or if you buy one for a larger dollar amount.
Why CDs Are a Good Investment for Some
CDs are usually issued by banks or credit unions. That means they are federally insured. So even if the bank goes broke, you won't lose your money (unless you have more than $250,000 invested in a single CD). With the stock market, you may end up losing your money if the stocks you invest in face hard times or some internet troll tweets something bad about a company.
A CD can be a good deal if you come into a bit of money that you don't need just yet, but you have an older car that may need to be replaced or you're thinking of taking a vacation in six months. A CD lets you put the money aside for an emergency, or large purchase, and keeps you from frittering it away on day-to-day stuff.
To debunk a rumor that CDs don't always pay a good interest rate, let's look at the Thrift Savings Plan (TSP) returns for its two safest options, the G and F Funds: For the last 10 years, the G Fund had a 2.3% rate of return, while the F Fund posted a 3.73% rate of return.
Doing a bit of internet searching showed me a "large credit union" offering a six-month, $1,000 minimum investment CD that pays 3.0% interest, and special deals such as a $50 minimum investment, 40-month CD that pays 3.75% interest.
So, if you do your research, a CD can be a better investment than the TSP.
What Is a Ladder CD?
A ladder CD is really a strategy of purchasing multiple CDs that mature at different times to take advantage of higher interest rates.
Once it gets established, a CD ladder lets you earn the higher yields offered on those longer-term CDs while still having cash in hand as the older "rungs" of the ladder mature.
You can create a CD ladder in any way you like, but the trick is to vary the maturity dates. Let's look at an example. If you had $5,000 to invest, you could spread out your money like this:
- $1,000 in a one-year CD
- $1,000 in a two-year CD
- $1,000 in a three-year CD
- $1,000 in a four-year CD
- $1,000 in a five-year CD
After your one-year CD matures, you can reinvest that money in a new five-year CD, which usually pays at least 1% higher interest than a one-year CD. When the second year ends, you can roll the money from your original two-year CD into a new five-year CD, and so on. You'll eventually reach a point where your ladder is made up entirely of long-term CDs, which earn the most interest.
You also can take the money out for emergencies, or add additional funds to the existing amounts.
Some banks and credit unions offer CDs that let you add money at any time, or special CDs that allow you to increase your interest rate at certain times during the life of the CD.
The bottom line is that you shouldn't overlook CDs as a valuable investment tool. Depending on your situation, they often make more sense than other financial products.
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