How to Invest With CDs

A certificate of deposit (CD) is a stable, short-term cash investment, like a traditional savings account or money market fund. This federally insured savings account can be a low-risk asset in your portfolio.

Advantages of CDs in Investing

CDs are commonly purchased through financial institutions like banks and credit unions. When you buy a CD, you are essentially loaning money to the financial institution, which then pays you back in fixed, regular payments.

You keep your money in the CD for a specific period of time in exchange for a monthly interest payment. The original investment is typically returned in a lump sum on what's referred to as the CD's maturity date. A CD has several investment benefits.

Predictable Income

CDs are typically viewed as a “set it and forget” investment, meaning no ongoing monitoring is required. CDs offer investors a safe place to earn a predictable income stream, particularly if using a CD ladder strategy, described later.

CDs typically offer higher interest rates than traditional savings accounts if you need to ensure access to your cash. Longer maturity dates tend to pay higher interest rates than shorter maturities, so investors with long time horizons have an even greater incentive to choose a CD instead of a savings account.  

Lower Risk

The Federal Deposit Insurance Corporation (FDIC), a government agency, provides up to $250,000 of insurance per depositor in the event of bank failure. The National Credit Union Administration (NCUA) provides the same level of insurance for credit union CDs.

The federal insurance makes CDs a low-risk investment that can add diversity to a portfolio invested in risker assets like stocks.

Low Minimum Opening

Many certificates of deposit have no minimum investment requirement or low minimums. So you don't need to save up a large amount or invest a large amount to start earning returns on your CD.

Disadvantages of CD in Investing

The simplest approach to investing in CDs is to buy one and hold it until it matures. There are several risks and limitations with this strategy. Let's look at the risks of investing in CDs more closely.

Interest Rate Risk

If interest rates rise, you can lose out on a higher rate if your CD hasn’t yet matured. Instead, your CD sits at the lower rate you originally received until it matures. If rates rapidly rise, you might miss out on the rate escalator. You may also miss out on returns from other higher-risk yet higher-reward investments if your investment portfolio is too heavy with CDs.

Inflation Risk

When inflation rises, the interest you earn on a CD may not keep up with the broader economy, decreasing your spending power. If interest rates are at 3% and inflation is at 5%, your CD's value will be worth less in a year—even before you pay taxes, which you'll also owe on interest earned.

Funds Access Risk

Another risk is tied to the fact that the money invested in a CD is usually unavailable to spend until the CD matures. Taking the money out early often results in a financial penalty. In addition, after maturity, there is typically a short window of time (often 7 days) during which investors can withdraw money from the CD. After that window, If you missed the window, the money is automatically reinvested in a new CD with a maturity length matching the CD that just matured.

Penalty Risk

Early withdrawal penalties can vary widely, with most providers taking a month or several months' worth of interest already earned as a penalty. Brick-and-mortar banks tend to have lower penalties than Internet banks, but regardless of institution, investors need to shop carefully and pay attention to the details.

Portfolio Construction

Early withdrawal penalties can present both short-term and long-term challenges. You may have unplanned spending needs and financial developments that require adjustments to your investments. Fortunately, some strategies help address these challenges.

CD Ladders

One option is known as a CD ladder. To construct a laddered portfolio, equal sums are invested into multiple CDs, each with a different maturity date. For example, a $100,000 investment could be spread out over 10 years as follows:

Each maturity date can be thought of as one rung on the ladder. This strategy provides defined CD maturity dates and a specific amount of money an investor can plan to have available on each date.

The money can be used to address spending needs. Or, if it’s not needed, it can be reinvested in a new 10-year CD to extend the ladder.

This strategy also offers flexibility to deal with changing interest rates. If rates rise, extending the ladder provides access to the higher rates. If rates fall, maturing assets can be moved away from CDs and into better-paying investments. Meanwhile, assets yet to mature benefit from being invested at a time when interest rates were higher.

The Barbell Strategy

If cash will be needed for shorter-term spending needs, such as in a year or two, and then again at a predetermined longer-term period, a barbell strategy can be employed. This involves putting a specific amount of money into a shorter-term CD and a second amount into a longer-term CD. Think of it as a ladder without the middle rungs.

The Bullet Strategy

Both of the previous strategies involve investing a sum of money all at once into CDs with varying maturity periods. The bullet strategy is like buying one rung of a ladder each year. But instead of extending the ladder with each new rung, all rungs mature simultaneously in the same year.

Suppose cash is needed for a large expense 10 years from now. Then, incoming cash flows can purchase a new CD each year for 10 years. In this case,

• CD 1 matures in 10 years
• CD 2, bought a year later, matures in 9 years
• CD 3 in 8 years, and so on.

When the CDs mature simultaneously in year 10, the money can be used for the designated purpose.

CD Variations

Traditional CDs are purchased and then held to maturity to avoid early withdrawal penalties. Because this model doesn’t fit every investor’s needs, there are a wide variety of innovative alternatives ranging from simple to sophisticated. Some of the more notable variations include:

Add-on CDs

Add-on CDs allow you to add money to a CD during the term, and may allow you to open the CD with less money than for a traditional CD. These can be a good option if you're still building a nest egg and hoping to increase your savings steadily over time. However, interest rates may be lower compared to a traditional CD.

Bump-Up CDs

Bump-up CDs provide an opportunity for investors to take advantage of rising interest rates by increasing the rate of interest paid by the CD. Shorter-term CDs are typically limited to a single increase, while long-term CDs may offer multiple increases. However, the rate may be lower than what you'd find with a traditional CD.

Jumbo CDs

Jumbo CDs typically require a minimum investment of $100,000, with a higher interest rate accompanying a higher minimum investment. Maturity dates vary. Investors with more than $250,000 to invest in CDs should make deposits at multiple banks to ensure the FDIC protects all of their assets.

No-Penalty CDs

As the name suggests, no-penalty CDs don't charge a penalty for early withdrawal before the term's maturity date. However, fewer term options may be available—for example, only a 13-month term. The interest rate may also be lower compared to a traditional CD.

The Bottom Line

CDs can be a low-effort, lower-risk addition to your investment strategy, which can help balance out risker investments. But investing in CDs also means you may miss out on better profits elsewhere, as rates vary widely across institutions, both brick-and-mortar and online. Like any investment, Carefully review your CD options before settling on one.