Safe Savings: Is now the best time to open a Certificate of Deposit (CD)?

As the US-China trade war wages on, markets around the world have taken a turn for the worse. For the most part, employment is the main consequence of Wall Street’s events, so aside from headlines, you may not have noticed much day-to-day change yet. As the sag continues however, big picture issues will start to become more visible, starting with bigger decisions, like investing and mortgages.

As operating costs go up due to tariffs the “cost of goods” will increase as well, this is known as inflation and is usually combated by the Federal Reserve with a decrease in interest rates. These interest rate adjustments can increase or decrease the amount of money borrowed and, in the case of higher inflation, they will cut the interest rate to make it easier for people to borrow money to buy more expensive products.

Why does any of this matter for your savings? Because banks use the Fed’s benchmark interest rate as their benchmark for the interest rates on your savings account, your car loans, and your mortgage. So when trade war news starts to churn up rumors that the Fed may halt its current plan of slow rate increases, and that they are even thinking about decreasing the interest rate later in the year, it can (and will) affect your financial plans, current and future.

You can find that a decreasing interest rate may be a nice thing if you bought a home at a higher one and have a “qualifying life event” that allows you to refinance. It can also be a bit of bad news however, especially for the savings tool we’re talking about today: a Certificate of Deposit. A Certificate of Deposit (CD for short) is basically a short- to mid-term loan from a banking institution that will pay you a set rate of interest over the length of the loan, at the end of which you also get your loan principal back. That means if you put in $1000 for a 24-month term, you are paid the interest at the agreed upon rate on your $1000, but at the end of the 24 months, you also get your initial $1000 back.

Give me the pros:

CDs are a very safe way to utilize some excess cash that you don’t need immediate access to, but aren’t willing to risk in something like the stock market. They are FDIC insured, so your money is safe and rates are generally set at the time of opening, so when a rate cut might be imminent, you can secure a higher interest rate on the money you put into CDs for up to a few years. Speaking of rates, of the safe savings options available, CDs often offer the best returns compared to things like savings or money market accounts. In addition to the security and potential for better rates of return, because CDs have you offering cash directly to the bank, they are widely available for free at almost any bank or credit union.

Now for the cons:

When going over the fine print on the paperwork, you will quickly figure out where most of the positives come from. As one of the options in the safe savings group, CDs get their great rates because they lack the accessibility that savings and money market accounts allow. While savings and money market accounts usually let you transfer freely without a fee (often within a limited amount or number of transfers per month), CDs generally require you to wait out the entire duration of the investment before accessing the funds, similar to government bonds. Sometimes you can withdraw early for a fee, but it’s usually pretty steep to dissuade you from doing so, and that can negate any profit you were going to make from it. The biggest drawback to CDs is also what makes them so safe: you miss out on the opportunity for exponentially higher yields in exchange for reducing the risk so significantly, especially compared to something like stocks or bonds.

In summary:

CDs can be an extremely powerful tool for the the conservative investor, especially when combined with compounding interest and time. Some strategists suggest a “waterfall” technique for CDs, wherein multiple CDs are opened at once with different durations. For example, you could open three CDs with a 12-month duration, 24-month duration, and 36-month duration, respectively. When the 12-month CD matures and pays out, the total yield (the interest plus the principal) can be rolled over into a new 36-month CD. This basically takes you back to the place you were in a year ago, with a 12-month, 24-month, and 36-month CD, but with more invested into the 36-month CD than before, and keeps perpetuating the one-CD-per-year pattern you’ve set in motion! This system will ensure that you compound the interest that’s paid out and utilize long-term CDs to capture the highest possible interest rate.

Now, this plan can take a hit in times like the present (mid-2019), when a rate cut down the line may mean a smaller amount of interest than initial calculations or previous payouts, so it’s important not to fully rely on money that’s been tucked away into investments. Emergency cash should always be a priority, and while the amount may differ from person-to-person or household-to-household, it can be a good idea to stay on the safe side and have about six months of typical spending set aside at any given time. This means if something were to happen (i.e. loss of employment, inability to work, etc.), you would have enough money sitting liquid in your savings account to pay your bills, put food on the table, etc. for six months. If you find that you’re someone who has difficulty not pulling from your savings, it might be best to put this emergency fund money into its own savings account that you don’t access regularly.

Once you’ve hit your emergency fund goal, you can continue saving and use the excess to open CDs with the confidence that you are able to safely part with that money for awhile. Keep in mind that longer-duration CDs will reward you with either higher interest rates or lower minimum principal requirements, so it can be a good idea to spring for a little longer of an investment to get more out of it in the end. When approached as a place to build up long-term cash to put towards a savings goal (think car, boat, or house), CDs can be one of the best ways to invest your savings safely.

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Featured image via: budgeting.thenest.com