HOW TO INVEST IN CDs
Certificates of deposit (CDs) have long been a low-risk investment option for savers seeking higher returns than regular savings accounts can provide. But, rates have recently dropped significantly. However, even when CD rates appear to be at rock bottom, there are strategies you can use to make the most of your money while also reducing the chance of missing out when higher rates appear.
Let's take a look at these strategies and some other ways you can invest in CDs.
3 MAIN STRATEGIES TO INVEST IN CDs
1. The Ladder Strategy
The most common CD investing strategy is CD laddering. Equal sums of money are invested in many CDs, each with a different maturity date, to create a laddered portfolio. Let's imagine you have $6,000 that you want to put into CDs. This is how a ladder might appear:
$2,000 in a 1-year CD
$2,000 in a 2-year CD
$2,000 in a 3-year CD
Each maturity date can be compared to a rung on a ladder. This strategy specifies a set of dates for each CD to mature and a particular amount of money that you can expect to have on each date. You can use the money to cover expenses or reinvest it in another 3-year CD, extending the ladder. This ensures that your money matures regularly, which provides you with two major advantages. First, you get regular access to some funds while earning long-term CD rates.
Second, this strategy allows you some flexibility in dealing with fluctuating interest rates. If interest rates have risen, extending the ladder allows you to access the higher rates. If interest rates have declined, maturing assets can be moved away from CDs into higher-paying investments, while assets yet to mature benefit from having been invested at a higher rate. It's important to note that you don't have to split the funds evenly, like the above. You can put any amount on each CD.
A CD ladder works best if you don’t withdraw money. So, be sure you have an emergency fund before investing in CDs.
2. The Barbell Strategy
A barbell, unlike a ladder, skips all the middle rungs and divides your CD into short-term CD investments and long-term CD investments. It entails investing a certain amount in a shorter-term CD and a different amount in a longer-term CD. Something along these lines;
Investing $2,000 in a one-year CD
Investing $2,000 in a 5-year CD
When your short-term CDs mature, you can reinvest in either short- or long-term CDs, depending on whether interest rates have risen across the industry. A barbell method can be used if cash is needed for short-term spending demands, such as in a year or two, and then again at a predetermined longer-term period.
3. The Bullet Strategy
The bullet strategy is similar to purchasing one rung of a ladder each year. However, instead of the ladder extending with each new rung, all rungs mature at the same time. You choose a target date for the bullet and invest in CDs accordingly. So you might invest in a 5-year CD right now, in a 4-year CD the following year, then a 3-year CD the following year.
This strategy allows you to access funds while you wait for interest rates to climb and until you're ready to lock in for a longer-term. As we said, all CDs mature at the same time, but the goal is for you to secure a better interest rate with each new CD, resulting in a higher average. You can also use current long-term rates to hedge your bets. In most cases, the overall return is a combination of short and long-term CDs.
A CD barbell is less diversified than a CD ladder, which makes it riskier in terms of missing out on potential higher rates. You can put more money on the short- or long-term end of the barbell, but only if you understand or consult with a financial advisor about how current financial markets affect CD rates.
By the way, many banks automatically renew CDs, so keep track of when your CDs expire so you don't lose out on the opportunity to take your money for free.
THE DIFFERENT TYPES OF CDs
CDs aren't all made equal. To avoid early withdrawal penalties, traditional CDs are purchased and held until maturity. Because this approach does not meet the needs of every investor, there are several innovative alternatives available, ranging from simple to sophisticated.
If you're looking for a CD to invest in, here's a breakdown of some of the most common alternatives:
1. Bear CD
Bear CDs are designed for sophisticated investors and provide a higher rate of interest when the value of a certain benchmark index decreases. Typically, investors buy them to protect themselves against potential losses in other investments.
2. Bull CD
Bull CDs work in the opposite approach of bear CDs, increasing the rate of interest charged when the value of a specified benchmark index rises.
3. Bump-up CD
Bump-up CDs allow investors to take advantage of rising interest rates by increasing the amount of interest paid on the CD. Let's say you start a 2-year CD with a 0.5 APY and it matures at 0.8 APY after eight months. You have the option to request a raise.
You should invest in a bump-up CD only if you're confident that rates will rise. You'll also need to keep an eye on prices to ensure that you don't forget to request your bump-up when rates rise. Because this isn't a fully automated process, you'll need to contact your bank.
4. Step-Up CDs
These CDs offer to raise your rate at regular intervals over the term. A step-up CD is similar to a bump-up CD, except the bank handles the paperwork. They guarantee automatic rate increases, so you won't have to do anything to get a better rate. Before you open, you'll have an idea of the rate rises.
While step-up CDs may appear to be a perfect answer to low CD rates, it's critical to determine the total annual percentage yield (APY) you'll earn over the term. In many circumstances, the combined rate of all your step-ups will be less than the straight APY you get from a traditional CD.
5. No Penalty/Liquid CDs
The name says it all. These products allow you to cash out before the maturity date, without penalty. You don't have to worry about forfeiting any earnings if you need money sooner than the maturity date. This could be a way for you to have the best of both worlds. You can take advantage of the current APY on the liquid CD while also having the option to cash out and reinvest the funds in a higher-rate CD if rates rise before the maturity date.
There's a catch, though. Because the bank benefits from having your money locked up for the period of the CD, these CDs typically have lower rates than their traditional equivalents. When rates are low, you might not find a liquid CD with an APY that beats inflation.
Banks may impose restrictions on the amount of money you can withdraw from your CD. After an initial waiting period, some institutions will allow you to withdraw your entire balance, while others will only allow you to take a portion of your balance.
6. Add-On CDs
Add-on CDs feel a bit closer to a standard savings account. After you open the CD, you can make additional deposits to the principal. Some add-on CDs will let you make an unlimited number of additional deposits, but others may have limits on how many times you make more contributions.
7. Callable CDs
Callable CDs give the bank more power to call – or close out – your CD. They can be redeemed by the issuer before the maturity date, usually within a specified time limit and at a predetermined call price. Let's imagine your CD pays a 3% annual percentage yield. If interest rates fall and the bank no longer wants to pay that much interest, your CD can be called.
8. Uninsured CDs
Uninsured CDs are not guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other institution. They offer greater interest rates in exchange for the risk of not having insurance.
While lower-than-expected APYs across the CD landscape can be disappointing, they aren't a cause to abandon CDs as a viable investment option. You can avoid CD pitfalls while getting the most bang for your buck by implementing one of the CD investment strategies.
If you think CD investing is a good fit for your budget, research interest rates to see where you can get the best return. Then consider how much money you have available to deposit and how long you are willing to keep it on a CD.