How to Invest in a Certificate of Deposit (CD)

A Certificate of Deposit is a low-risk alternative for investors seeking a higher rate of return as opposed to a standard checking or savings account. Certificates of Deposit (or CD’s) are a viable option for investors of all ages and risk tolerances who do not need immediate access to a portion of funds but do not want to invest those funds in other investment vehicles like a mutual fund or stock. Unlike a Checking or Savings account, a CD will typically come with a set length of maturity referred to as a “term”, during which the funds cannot be withdrawn. If an investor wants to withdraw funds before the CD matures it can be done, but with a penalty fee being incurred.

With the general basic workings of a CD in mind, here are a few points to consider when determining how to invest in one.

Time Horizon

The first step in considering how to invest in a CD is choosing your term.
Terms vary in length and many banks will offer a term as short as 3 months and they can range all the way up to 10 years. As the term of a CD increases, the interest rate will typically increase also, providing an incentive to leave your funds invested for longer. For an investor who may need to access the funds in a relatively short time frame, a shorter term CD is recommended, and if the funds aren’t needed then they can buy another short term CD when the first one matures.

Yields and Rates

After choosing the specific term of a CD, the next step will be finding the highest interest rates. To ensure the highest percentage returns, an investor will want to contact several financial institutions and get a list of rates for the term they have chosen. Some institutions will have the rates published on their website. The Annual Percentage Rate, or APR, is the rate typically quoted related to a CD and is the amount of interest that the CD would generate on an annual basis. Many longer term CD’s will also list the Annual Percentage Yield, or APY, which will indicate the yield on the CD when accounting for the compounding of interest.  This is important to note when looking at CD’s with a 3,5 or 10 year term.

Types of CD's

The most common Certificate of Deposit is a traditional CD which will give you a fixed rate for the life of the chosen term.  In addition to the traditional CD, there are more complex CD’s offered with more complex terms or features.  A common example of a non-traditional CD is one with floating interest rates, where the rate will change monthly or quarterly based on changes in an underlying base rate. Other non-traditional CD’s include those with favorable early withdraw terms (usually at a cost in terms of interest paid) or CD’s that offer the ability to swap interest rates or re-invest in a higher rate CD should interest rates change substantially.

Certificates of Deposit can be a useful addition to many investors’ portfolios as they provide a low-risk component, and depending on the terms structures, can provide regular cash infusions to a portfolio to either be reinvested in another CD or allocated elsewhere.  They do offer lower returns than most bonds or mutual funds, so this does come at a cost.
By Jeffrey Glen

Copyrighted 2020. Content published with author's permission.

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