So, you’ve got some extra money just hanging out in your bank account, and you’ve decided to put it to good use. After all, certificates of deposit (CD) have great interest rates right now, so why not take advantage of them?
Don’t get too ahead of yourself — before you start your CDs adventure, consider these three really important things.
1. Rates are not always better the longer you save
It might feel like your rate should be bigger the longer you leave your money in the certificate of deposit. After all, that’s more time the bank can use your money without worrying about having to replace it. But sadly, that’s just not how it works.
Rates are set according to how the bank sees the future unfolding, not how long it gets to hold your money. All of this is based on U.S. Treasury securities and their interest rates. Treasuries mature at different paces, with three months, two years, five years, 10 years, and 30 years being common. Typically, the longer the security type lasts, the more investors demand back in interest.
However, sometimes something called an inverted yield curve occurs, which means that shorter-term securities are actually paying better interest than the longer-term securities. In this case, shorter-term CDs will also pay better interest rates than longer-term CDs. An inverted yield curve can help investors with quick short-term gains, but can also signal a recession is on the horizon.
An example of an inverted yield curve is happening right now. As of the writing of this article, Quontic has the best annual percentage yield (APY) available for a CD, 5.30%, but it’s for a 1-year CD. The worst rate that we’re tracking is available through Ally and Capital One, which is 4.10% on a 5-year CD.
2. CD maturity behavior isn’t consistent
A lot of people don’t consider what happens when the CD they’re considering matures. This is something you’ll have to check with your bank to find out for sure. You can’t automatically assume your money will be deposited into your account, because sometimes it’s automatically reinvested.
“But that sounds awesome,” you think to yourself today, a year before your CD is mature. And it might be. But especially if there’s an inverted yield curve, you really don’t want to just let that happen. When a CD is automatically renewed, it’s renewed at whatever rate is current for your bank and the product your money was in.
A lot of things can change in a year, so you might go from that 5.30% 1-year CD into an auto-renewed 2.5% APY 1-year CD, when there’s a 6-month CD out there with a 4.0% APY. Always be aware of your CD and watch it closely as renewal approaches. You’ll only have a small window to do something with a CD that’s set to auto-renew.
3. CDs have withdrawal penalties
Although a CD seems like a fairly liquid account, there can be pretty stiff penalties if you choose to withdraw your money early. That’s why it’s so important to choose a CD investment period that makes sense for your life and how it ebbs and flows. Every penalty you pay will reduce your effective annual percentage yield and cost you money.
Most of the time, the penalties are some amount of interest that’s accumulated on the money you’ve withdrawn, based on the length of the CD and when you take the money out. This can vary from a week’s worth of interest to a year’s worth — or even more. There may also be additional withdrawal fees, depending on your bank’s policies.
So whatever you do, don’t sign up for a 10-year CD with money you know you’re going to need in five years. For example, I have a friend who put her son’s college money in a high-yield CD last year. She knew when he’d be leaving for college and when that money would need to be freed up again. She chose a CD length that was both high in interest and compatible with her need, so that she can take the money out in time for Freshman Move-In Day.
Investing in CDs can be a great strategy, if you read the fine print
Certificates of deposit are really fantastic savings vehicles for many people. It’s a kind of out-of-sight, out-of-mind product that forces you to save money in the least intimidating way possible. And right now, they’ve got really great returns, so there’s no reason not to get one or two or 10, if your heart desires it to be so.
No matter how you manage your CD empire, though, start by reading all the fine print, comparing CDs, and fully understanding all the terms involved, including anything related to auto-renewal. This will help you maximize your returns on your savings and ensure it’s a great experience.
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