Investing 101: What is a CD and are they right for you?
Why do people invest their money? It’s likely because they’re saving for something—a trip, a home, a child’s college education—or simply because they don’t want to work until they’re 108. People earn money by working, but putting your money to work is also an excellent way to build wealth and help you afford the things you want in life.
Investing is the most effective way to grow your money over the long term, but risking what you already have for the prospect of something more in the future can be a scary thought. Couple that with the complexities of the financial markets and it’s easier just to stuff some cash under your mattress.
The truth is, investing doesn’t have to be complicated. In fact, there are some conservative options that can help you earn extra cash without pushing you beyond your comfort zone. Both seasoned and novice investors can benefit from the safer, simple choices, like a CD, for instance.
What is a CD and how does it work?
A certificate of deposit (CD) is a promissory note that’s issued by a bank or credit union. It comes with a future maturity date and a fixed interest rate. When you invest in a CD, you, as the investor, agree to loan your money to the issuing institution for a specific period of time and a predetermined rate of return.
When you purchase a CD, you give up access to your funds until the maturity date. For forfeiting your liquidity, you earn compensation in the form of interest. Once the CD matures, the bank refunds your initial investment, which is called the principle, plus your earned interest.
CDs are issued for different terms. Long-term CDs typically offer a higher rate of return compared to short-term CDs. Why? Because your restricted access to the funds is for a longer timeframe and the longer you’re required to hold your investment, the higher level of risk and uncertainty you assume.
How risky are CDs?
On the spectrum of risk and return, CDs are considered conservative investments. Federally-insured bank CDs are backed by the Federal Deposit Insurance Company (FDIC), and Credit Union issued CDs are guaranteed by the National Credit Union Administration (NCUA). Even if the issuing institution collapses, your investments are protected.
The risk that you assume with CDs is interest rate risk. When you invest in a CD, you agree to a specified rate of return. As the financial markets fluctuate in response to economic and political factors, you want your CD’s rate of return to remain competitive. If CD rates rise, your current investments could be locked into a lower rate for an extended period of time. While you don’t run the risk of losing your investment and your earned interest, but you could miss out on the opportunity to earn more money than with your current CD.
One way to reduce that level of risk is called laddering. You can stagger maturity dates among several CDs so that matured deposits can be reinvested at potentially higher rates and you’re able to gain periodic access to cash, if necessary.
Explore your options
As with any investment, be sure to familiarize yourself with the fine print. A common concern with CDs is penalties for early withdrawal. If you experience a hardship and have to cash in your CD, it could significantly affect your earned interest or even your principle. Today, there are specialty CDs like penalty-free CDs, Bump Up or Raise Your Rate CDs, IRA and Jumbo CDs. If you’re considering an investment, be sure to speak with your financial advisor to determine which options will meet your individual needs, both in the short and long term.