Investing in CDs

Answer 1

You’ve probably seen advertisements for CDs at your bank or even in your email inbox if you do any online banking. What is a CD? A CD is a Certificate of Deposit. It’s essentially an account that is set up between you and your bank with an agreement that you will not touch the money until the CD matures. So by introducing the element of a maturity, CDs are similar to bonds. (It should be noted that some CDs will allow you to take money out prior to maturity but you will pay a stiff penalty for early withdrawal.) So why would anyone agree to tie their money up for a set period of time when they could simply put it in a savings account at the same bank? Well, the bank benefits by having an idea of how long that money will be parked in the account. For them the money and the timing of its withdrawal are more of a known quantity and this fact allows the bank to make more informed decisions with their reserves. Because they benefit from it, and because you’ve given up something – the unhindered liquidity that a demand deposit account would afford you – CDs pay out a higher interest rate than regular bank savings accounts. But these accounts will not pay out interest rates like certain bonds. And they most likely will be outstripped by equity investment growth rates in most years. So why invest in CDs? Well, they are a great place to stash an emergency fund. They are FDIC insured deposits. And while it’s true they’re less liquid than a demand deposit account, if you place portions of your emergency fund into high-yield CDs with staggered maturities, a technique known as laddering, you’ll always have some money becoming available every so often. If you do choose to use CDs, I’d recommend putting a portion of your emergency reserve into a regular demand deposit account so it’s more liquid. The rest can go into your CD ladder and when the individual CDs mature, if you don’t need the money, roll them into other CDs to keep the laddering going.