So now that I have some extra money in my bank account, I decided to put it to good use. After all, interest rates on certificates of deposit (CDs) are very high right now, so why not take advantage of them?
Don't get too ahead of yourself. Before you begin your CD adventure, consider three very important things:
1. The longer you save, the better your interest rate will not necessarily be.
You may feel that the longer you leave your money in a certificate of deposit, the higher your interest rate should be. After all, that gives you more time to spend without worrying about the bank exchanging your money. But unfortunately it doesn't work.
Interest rates are set based on how the bank sees the future unfolding, rather than how long you hold your money. These are all based on US Treasury bills and their interest rates. Government bonds come in a variety of maturities, with three months, two years, five years, 10 years, and 30 years being common. Typically, the longer a security type lasts, the more interest investors demand.
However, a phenomenon called an inverted yield curve may occur. This means that short-term securities actually pay higher interest than long-term securities. In this case, a short-term CD will pay a higher interest rate than a long-term CD. An inverted yield curve can provide short-term gains for investors, but it can also signal that a recession is on the horizon.
An example of an inverted yield curve is occurring right now. As of this writing, Quontic's CDs have the highest annual percentage yield (APY) at 5.30%, but this is for his one-year CDs. The worst rates we track are available through Ally and Capital One. This is 4.10% for a 5-year CD.
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2. CD maturity behavior is inconsistent
Many people don't think about what the CD they're considering will look like when it's finished. To be sure of this, you should contact your bank. You cannot automatically assume that the money will be credited to your account, as it will be automatically reinvested in some cases.
Today, a year before the CD is completed, you think to yourself: Maybe so. But you don't want to leave it alone, especially if there's an inverted yield. If your CD renews automatically, your CD will renew at the current rate of your bank and the instrument the money was in.
A lot can change in a year, so if you have a 6-month CD at 4.0% APY, you could go from a 1-year CD at 5.30% to an auto-renewing 2.5% APY 1-year CD. There is a gender. Stay aware of CDs and check back for updates as they become available. There is only a small window to do anything with a CD that is set to auto-update.
3. CDs have withdrawal penalties
CDs seem like fairly liquid accounts, but if you choose to withdraw your money early, there can be some pretty severe penalties. That's why it's so important to choose a CD investment period according to your life and its ebbs and flows. Each penalty you pay reduces your effective annual yield and costs you more.
In most cases, the penalty is a set amount of interest that accumulates on the money you withdraw, based on the length of the CD and when you withdraw the money. This can vary from the equivalent of a week to the equivalent of a year or even more. Additional withdrawal fees may apply depending on your bank's policies.
So whatever you do, don't sign up for a 10-year CD with money you know you'll need in five years. For example, I have a friend who put his son's college money into his high-yield CD last year. She knew when he was going to go to college and when he needed to free up that money again. She chose the length of her CD that was of high interest to her and suited her needs so that she could withdraw the funds in time for her freshman year's move-in date.
Investing in CDs can be a great strategy if you read the details.
Certificates of deposit are a really great savings vehicle for many people. This is the kind of product that is invisible and out of your consciousness, forcing you to save money in the least scary way possible. And now they're getting really great returns, so there's no reason not to pick up one or two or even ten if you want.
But no matter how you manage your CD empire, start by reading all the fine print, comparing CDs, and fully understanding all relevant terminology, including those related to automatic updates. This will help you maximize your savings and ensure you have a great experience.
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