Here’s What Has Changed
Certificates of Deposit (CDs) are not glamorous, but they are investments worth considering in 2023. That is a change from the past decade, where they languished in the eyes of savvy investors.
CDs are contracts (generally) between a depositor and a bank, where the client deposits money and agrees not to withdraw it in exchange for a return of interest payments.
Since The Great Recession, interest rates have been near historic lows. As a result, banks did not have to pay depositors that held these certificates much in interest payments. After all, no other safe investments, such as money markets or bonds, were paying substantial interest either.
If an investor wanted to receive meaningful yield, they had to take on risk in the stock market or elsewhere, which was rewarding until the Covid Crash in 2020.
Nearly immediately, the Federal Reserve pumped the markets full of cash, and the US Government gave business owners practically guaranteed forgivable loans for payroll and most people stimulus checks, which staved off a major recession that year. But with these actions and pent-up consumer demand after a waning pandemic, inflation exploded in 2021, and with it came nearly unprecedented rate increases by the Federal Reserve.
Nowadays, certificates of deposit are attractive investments for those willing to lock up their cash for a couple of years with a bank. After all, if a bank wants to guarantee it can loan out someone’s money for several years, it must now pay more to these depositors, or they will take their money elsewhere.
A quick look online and CDs that mature in the next one to three years pay up to 5.5%! That makes today’s CD rates substantially higher than any seen in over a decade.
The Premise of CDs
Certificates of deposit come in two forms: traditional and brokered.
With traditional CDs, the depositor agrees to leave their funds with a bank for a given timeframe in return for guaranteed interest. These conventional CDs pay compound interest that accrues daily.
If depositors need their funds back before the end of the contract with a bank, they pay a penalty. The early redemption penalty is a deterrent for such transactions since they force banks to reallocate funds from elsewhere; in theory, the bank had loaned the money out and wasn’t ready to return the funds yet.
With brokered CDs, brokerage firms purchase these instruments from banks in considerable quantities, which usually secures higher interest rates for their potential clients, but with added fees.
Unlike traditional CDs, brokered ones can be bought and sold during market hours and fluctuate in value, similar to bonds, based on their printed interest rate compared to the current rate. Further, they (generally) only pay simple interest compared to compound interest.
FDIC Insurance
Most CDs of both variants are FDIC insured; with traditional banks, coverage is up to $250,000. However, many brokerage firms offer FDIC insurance up to or above $1,250,000 due to cash sweep programs that cycle client cash and CDs through various concurrent banks.
High yields and duration
Currently, the best rates for CDs are those for one year, followed by three years, and then five years. Given our current economic environment and the likelihood that the Fed will continue to raise rates, one to three-year CDs probably make the most sense for people’s cents.
Generally, CDs require a minimum deposit of $1,000.00 with a bank or broker, but each issuer’s requirements will vary. Some firms require a minimum purchase of $2,500; others require more, such as $10,000. With brokered CDs, additional increments usually must be purchased in $1,000.00 units, but this is only sometimes the case, and some firms offer fractional purchases.
As of writing this post, FDIC-insured CDs are paying up to 5.5% for one-year and 4.3% for three-year deposits. I suggest a quick internet search and using a reputable company like NerdWallet that lists various offerings to find a satisfactory CD. However, be wary and always check multiple websites before making a decision!
CD Ladders
A strategy often used when purchasing individual bonds, known as laddering, is something CD holders can utilize too.
By purchasing CDs with different durations (i.e., the time until they mature, such as one, three, or other year-numbered increments), investors can create a ladder to receive matured CDs at intervals that align with their future income needs. Such a strategy diversifies yields and issuers to provide some interest rate and issuer protection (though the latter point is mute if FDIC coverage applies).
Overall, CD ladders are an attractive, nearly risk-free option when done using FDIC-applicable CDs within the covered limits.
Holding CDs In an IRA
CDs pay interest to the depositor, taxed as ordinary income. However, CDs are investments banks and brokerages offer within traditional and Roth IRAs, meaning the interest income is deferrable or not taxable, depending on the account type!
While younger investors should focus on holding stocks within their retirement accounts, retirees or those nearing retirement can benefit from an allocation to CDs in their IRAs if they plan on withdrawing the funds in the next few years. Retirees could also use CDs as an alternative to bonds in the near term to provide a safe but higher fixed-income yield.
To learn more about the differences between traditional and Roth IRAs, check out my foundational article, Traditional or Roth: How to Choose.
Pitfalls of CDs
As mentioned above, if depositors need their funds back before a CD matures, they are penalized for making an early redemption. Such penalties vary, but they cost the investor money and require one to be mindful of their liquidity needs. Notably, no-penalty CDs exist but pay lower interest rates for the opportunity for withdrawal at any time.
Furthermore, the opportunity cost of locking up money in a CD versus dollar-cost averaging into the stock market is a fundamental consideration young investors or those with longer time horizons must make. After all, no one knows when the market will rally next, and timing the market does not work for nearly anyone (even the so-called pros).
Do You Own A CD?
Certificates of deposit have gone from being relegated to the sidelines to a robust financial vehicle in 2023. What is your experience with CDs? Do you currently invest in them, or have you in the past? Please let me know in the comments below, and as always, have a great day!
Mile High Finance Guy
finance demystified, one mountain at a time
