Mistakes to avoid when investing in CDs
With the Federal Reserve pushing interest rates higher over the next several years a new era of rising returns is upon us.
As yields increase, certificates of deposit are expected to regain some of their past glory as profitable, reliable vehicles for outearning your savings account while still safely preserving capital.
But maximizing your CD earnings will require more than just showing up for the party.
In fact, there are as many pitfalls to avoid as there are opportunities to capture. So be careful to avoid these costly CD mistakes.
Mistake 1. Not being ready for the Fed rate hikes
CD savers who don't follow Federal Reserve headlines do so at their own peril, as they could easily lock in a CD yield right before the Fed announces a rate hike.
The Fed's rate-setting committee meets every six to seven weeks to decide whether it will modify the federal funds rate.
That rate is the interest commercial banks pay to borrow money from each other through the Fed, and it's the lever the Fed uses to manage short-term interest rates across the broad economy.
For seven years, the Fed has kept this rate at near-zero as a stimulus to help the economy recover after the 2008 financial crisis, and during that time savings, money market and CD yields have languished at historic lows.
But in mid-December the Fed reversed course and pushed the fed funds rate up by a quarter point. It plans to continue adding a percentage point a year — probably with a quarter-point hike at every other meeting — until it reaches 3.50%.
The only other time the Fed methodically raised rates from an exceptionally low level was in 2003. Back then, the Fed rate had plateaued at 1.00% and was incrementally boosted to 3.50% over the next two years.
When the fed funds rate was 1.00% in 2003, the average 1-year bank yield was 1.26%, and the average 5-year yield was 3.02% APY.
By the time the Fed increases reached 3.50% in 2005, the 1-year CD average had climbed to almost 3.00% APY and approached 4.00% for the 5-year average.
In stark contrast, today’s national averages for 1- and 5-year CDs are an anemic 0.28% and 0.86% APY.
No one knows how dramatically or quickly commercial banks will respond this time around, and looking at what happened to rates in 2003-2005 could suggest undue optimism, since the last seven years of Fed history are completely unprecedented.
But it's reasonable to anticipate CD yields climbing regularly and possibly significantly while the Fed hikes rates, with higher yields being triggered perhaps every three months or so.
Mistake 2. Buying long-term CDs that are costly to exit.
Because the Fed's increases are expected to take place over the next three years, committing to today's rates for a 4- or 5-year CD can hurt you twice.
First, you'll under-earn future yields by a significant margin in the fourth and fifth years, since rates will have been on a three-year climb.
How much do CDs pay?
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Second, locking your funds in for such a long period prevents you from moving into better-paying CDs as they arrive.
In an era of rising rates, liquidity and flexibility offer you an edge, so always be sure to review the early-withdrawal penalty for any bank where you're considering opening a CD.
A typical penalty is 6 months' interest, and on a 5-year CD that can be a reasonable forfeiture in exchange for being able to move your money to a new, better-paying CD.
But other banks charge 12 months' interest or more. Some even assess penalties that can subtract from your principal.
So when faced with the choice between two CDs of similar merit, opt for the one with the most lenient early-withdrawal penalty.
Mistake 3. Putting all of your money in one basket.
When money experts talk about diversity, they usually mean divvying up your savings between different types of investments, such as domestic and foreign stocks, bonds and CDs.
But holding a diverse portfolio of CDs, with a range of maturity dates, is important too.
The classic way to do this is through "laddering," or buying an assortment of certificates in increasing terms.
That provides a regular supply of maturing CDs that can be reinvested at higher returns.
Additionally, it's useful to diversify across banks.
If you're investing more than $250,000, you'll definitely want to deposit your funds in multiple institutions because federal deposit insurance maxes out at $250,000 per depositor per bank.
Even if you don't have that much, capturing the very best yields will typically require buying CDs from more than one bank, since it's rare for one institution to offer a leading rate in all terms.
To find the best returns at any time, search Bankrate's database of the top CD rates from around the country.
Mistake 4. Not shopping around for the best returns.
Buying CDs from the bank where you already have your checking account may seem practical. But in most cases, convenience is the only advantage you're gaining and at a significant cost.
That's because most of the nation's biggest banks pay below-average returns.
Fortunately, dozens of national banks offer CDs paying three, four or even five times more than the national averages.
For instance, the top nationally available 3-year CD currently pays 1.85% APY, while the national average is a paltry 0.55% APY.
Credit unions and community banks are another source of chart-topping CD rates, with local offers often outpaying the nation-leading banks.
Mistake 5. Putting the wrong money into CDs.
CDs are a smart place for money you don't need in the short term but aren't comfortable putting in riskier investments, like the stock market.
Savers can err in either direction here. Put money into CDs that you end up needing in the near term, and you'll be slapped with an early-withdrawal penalty that may wipe out the advantage you gained by opening a CD instead of a savings account.
But if you're holding money for five years or more (some CDs have terms as high as 10 years), many financial advisers would tell you to invest in stocks instead. At today's depressed returns, chances are high that the stock market will do better over the long term.
Of course, this advice will change if CD returns climb to 4% or 5%, making them more worthy alternatives.
Mistake 6. Letting your CD automatically roll over.
When a CD approaches maturity, the bank will notify you that the term is ending. If you do nothing, the bank will automatically roll the proceeds of your expired CD into a new CD with a similar term.
Letting the bank do this is almost always a mistake.
As you've learned above, you should choose your CD terms wisely based on what's happening with the Fed. Just because you have a 3-year CD maturing doesn't necessarily mean you should replace it with another 3-year CD.
Even more important is shopping around for the very best rates. Although it's possible that the bank with your existing CD offers the best current rate, it's more likely you'll find a stronger yield elsewhere.
Joining the savviest of CD savers is as simple as avoiding these mistakes. Steer clear of them, and you'll not only earn the highest yields but enjoy useful flexibility as we approach this brave new world of increasing rates.