Navigating the world of investing and personal finance can be a daunting task. Knowing where you stand and which investment path is right for you doesn’t normally come easy. Walking into an average bank with money you want to invest will probably produce more questions than answers.
Unless you are an investment banker and all of this comes second nature to you, it’s beneficial to have guidance. Below you will find information about one form of a personal investment called a fixed-rate certificate of deposit (CD). This is a valuable way of making your money go further for you over a fixed amount of time.
What Is A Fixed-Rate Certificate Of Deposit?
A fixed-rate certificate of deposit (CD) is a way of investing where the interest rate is set or fixed over the entirety of the term. Once it matures or the term ends, the CD can either be withdrawn by the holder for cash or be rolled over into a new CD. Long-term CDs pay higher rates, but there is a penalty if you take out the money too early.
Terms usually can run anywhere from three months to ten years. Over that time, your fixed-rate CD will grow—slowly, but steadily—until the term expires. Most CDs range from a year to five years because the majority of people don’t want their money tied up that long. The minimum deposit amount depends on your bank in Texas, credit union (where they are commonly called ‘shared certificates’) or financial institutions.
The other most common type of CD is a variable-rate CD. A variable-rate CD is different because the interest rate varies based on market factors.
How Do CDs Work Differently Than A Regular Bank Account?
While they sound identical in function, a few key differences set a fixed-rate CD apart from a run-of-the-mill savings account at a bank. With a savings account, you are at almost complete liberty to deposit and withdraw whenever you choose. This is not the case with CDs.
You will enter an agreement with your bank representative to leave your money in the bank for a set amount of time. The only way to get your money out before it matures is to pay a hefty penalty against the balance of your CD. It is important to think carefully about how long the term of length on your CD should be as you don’t want to be penalized.
Another big difference is that while interest will accrue in your savings account, it doesn’t compare to the rate with which it accrues in a CD. Many of the best 5-year CDs have eclipsed interest rates of 3% APY whereas the average APY of a savings account is around 0.06% APY.
If the money is for an emergency fund in case you lose your job or get sick, then it’s better off in a savings account. The average penalty for cashing a CD out early is seven months’ worth of interest, which cancels any benefit of putting the money in a CD in the first place. Additionally, no federal or credit union insurance covers penalty withdrawals.
What Are The Benefits Of A Fixed-Rate CD?
There are some well-established advantages of fixed-rate CDs over a regular bank account, but what about other forms of CDs. What are the overall benefits a fixed-rate CD can give me?
Compared to their counterparts, a fixed-rate CD is a low-risk option as the interest rate stays locked in, no matter what the market does. This provides a steady way of increasing the amount you save that won’t fluctuate if the economy fails.
Another benefit of a fixed-rate CD is that they are 100% backed by the Federal Deposit Insurance Corporation (FDIC) up to $250,000. With a federal guarantee that you will never lose the principal deposit, a fixed-rate CD carries less risk than bonds, stocks and other, more-risk prone investment options.
Not only are their interest rates higher than a normal savings account, but a fixed-rate CD often comes with a better rate than other low-risk investments, such as money-market accounts or money market funds.
You can divide the money to be invested into equal amounts in CDs with different maturity dates. This strategy is known as “laddering.” This option decreases both the interest rate and reinvestment risks. A laddered CD account can still provide quarterly payments with a much higher total portfolio rate of return.
Shop around for the best rate before choosing where to put your money. Small, local banks and credit unions often offer better rates than larger ones. A bank that is strictly online will also offer higher rates because their costs tend to be lower than brick and mortar banks. However, online banks aren’t normally as good about customer service as a bank with a physical location.
Are There Any Drawbacks?
With almost any investment plan, there are some trade-offs when it comes to CDs. The main one is that your money is tied up for the duration of the length of the term. This can cause problems if a snap investment opportunity or an emergency comes up.
As stated before, the penalties levied on premature withdrawal are hefty and negate most, if not all, of the reason to invest in a CD. Some CDs come with a bit more flexibility regarding early withdrawal, so be sure to ask your bank if they offer these types.
Another drawback is that a fixed-rate deposit isn’t the fastest way to grow your income. You may go with a fixed-rate CD because it’s the safe, steady option and watch your friend’s variable-rate CD skyrocket due to a favorable market. Some banks offer “no-penalty CDs” that allow you to get your money back without charge any time after six days, but these don’t pay as well as a regular CD.
The last big problem with fixed-rate CDs is that they don’t pay enough to keep up with the rate of inflation. Over time a person who only invests in CDs will lose their standard of living. It’s vital that you diversify your investments and not put all of your eggs in the CD basket.
How Do I Know A Fixed-Rate Certificate Of Deposit Is Right For Me?
With so many ways to invest, how do you know which path to take? Not only are there CDs, stocks & bonds, money-market accounts and more, but there are also several different types of CDs. So how do you know which one to go with?
Let’s start by going into some of these different kinds of CDs. While most come with fixed-rates, there are bump-up and step-up CDs that allow you to increase the yield before the term is up. Zero-coupon, callable and high-yield CDs enable you to earn at a more competitive rate and jumbo CDs require a high minimum deposit. There are also brokered and liquid, add-on and IRA CDs that come with their own set of benefits and shortcomings.
You can leave the emergency fund in your savings account and start a new account at your bank in Texas, specifically meant for a CD. That way you’re covered if misfortune should come while still preparing for the future.
Also, if you can a lot of money tied up in investments like stocks, bonds and money market accounts, a fixed-rate CD is a great way to diversify your investments.
Your Financial Well Being is Up to You
Hopefully, this article has provided solid insight into all facets of fixed-rate CDs—who they are right before, how they differ from other savings and investment options and their pluses and minuses. Knowing more about what options are out there encourages people to maintain good personal finance habits so they can make their money work for them, not the other way around.
Too many people feel ill-equipped to take on their finances and neglect issues like investing, financial health and retirement because they worry about how bad the state of things are. Facing your financial future doesn’t have to be like going to the dentist and shouldn’t invoke the same feelings of anxiety, dread, and panic.
Just as your dental health is almost entirely up to you (not your dentist) so is your financial well-being. We all have to start somewhere and the sooner people tackle the financial problems they have, the sooner those issues will disappear. It’s not magic. It takes a lot of work but once you are armed with the knowledge needed to secure a brighter financial future, you would be surprised just how fast you begin to see the light.