Are CDs Still a Worthwhile Investment?

Certificates of Deposit (CDs) have long been valued as low risk investments that provided sufficient return to justify having funds unavailable for potentially lengthy periods of time. Given the current low interest rate environment, however, is this still the case? Chasing yield can have its benefits, but it can be a time consuming process and one fraught with potential pitfalls, so it’s best to educate yourself on the options prior to pursuing such an investment course. Fully understanding what a CD is, what varieties are available and what strategies can be employed to maximize your return are steps that must be taken to become a well informed investor.

Consumers searching for low risk investments often turn to CDs, a time-based deposit account with a bank or thrift institution that typically offers a higher rate of interest than a regular savings account. Like traditional bank accounts, they are insured by the FDIC up to $250,000 per bank per account category. Investing in CDs involves opening an account into which is deposited a fixed sum of money for a fixed period of time. In exchange the bank pays interest, typically at regular intervals until the CD matures, at which point the original investment, as well as any remaining accrued interest, is paid out. If the investor chooses to redeem the CD prior to its maturity date, there will often be an early withdrawal penalty applied. Ensuring that access to the invested money won’t be necessary, therefore, is a key requirement prior to opening a CD account.

Historically there has been only a single type of CD available to consumers; one that pays a fixed rate until maturity. In recent years this type of CD, commonly referred to as a traditional CD, has been augmented by a variety of CD types with an array of features available. Some have smaller withdrawal fees, others special redemption features if the owner dies, but the most common non-traditional feature involves getting paid a variable interest rate. These rates are often based on a pre-set schedule or tied to a specific index like the S&P 500.

The most common method for buying a CD is to open an account with an FDIC insured bank. There are other options, however, including going through brokerage firms or agents. This latter approach is most frequently employed by consumers looking to place their funds in a co-mingled account representing the investments of multiple consumers, as opposed to the more traditional individually owned CD. There are risks inherent in using an agent or brokerage firm not present when opening an individual account through a bank or thrift. FDIC coverage may not be applicable if an incompetent or dishonest broker or agent does not properly establish or maintain the CD account on your behalf. Not all institutions that sell such CDs are even eligible for FDIC coverage, so ensuring that they are represents a crucial part of investment due diligence. The account must be designated as a “deposit” in order to be covered by the FDIC; not all are, especially when purchased through an agent or broker. CDs have no contractual contingencies as the bank is unconditionally obligated to pay the full principal amount upon maturity; if there are any contractual contingencies present than the account cannot be designated a “deposit” and will not be eligible for FDIC deposit insurance.

Once educated on the product, an investor must decide on how best to employ that product within an investment strategy. The traditional method of squeezing maximum yield from CDs is an approach known as laddering. This involves opening numerous CD accounts that will mature at various times in order to generate a regular cash flow as CDs mature; benefits of this approach include the maintaining of high levels of liquidity that can be maneuvered to take advantage of rate movements. Due to years of record low interest rates, this method is not as viable as it has been in the past. Conservative investors or those who are interested in having a place to park emergency funds will find that this strategy remains useful as it keeps their money safe via the FDIC coverage and the funds are easily accessible. Poor yields, however, make this a difficult way of generating return. Core inflation is generally around 3% a year and with the average twelve month CD currently only paying 0.5% in interest, these investments don’t come close to keeping pace with the increasing cost of living.

Generally, investing in CDs with longer maturities has been more profitable as they have typically paid out at higher interest rates; now with even long term interest rates at historical lows, this strategy is no longer feasible. A better approach is to invest in shorter term CDs, thus maintaining liquidity which allows the consumer to take advantage of reinvestment opportunities once rates eventually rise again. This involves, however, a great deal of time and is likely only worthwhile for those investors with sufficient funds to justify the effort.

With laddering no longer as profitable as it has been in the past, more creative ways are needed to make money when investing in CDs. One way is to take advantage of promotional or bonus rates being offered by institutions looking to entice new customers into purchasing their products. These types of rates are most commonly offered by credit unions or smaller community banks and usually apply only to “new money”, that is money coming from elsewhere as opposed to rolling over an existing CD at the same bank into a CD that offers the superior rate. These rates are usually introductory only, and therefore time limited, thus often leading to the necessity of having to move the money upon the rates expiration. If you have sufficient time to find and take advantage of these rates and sufficient funds to generate requisite return, this can be a profitable strategy, relatively speaking. According to NerdWallet, from September 2011 to September 2012, bonus rates added an average of 0.68% over non-bonus rates. With this taken into account, shorter term CDs are now actually out-earning longer maturity CDs, which has rarely been the case in the past. There are caveats: in addition to having to find the rates and then most likely move the money in a fairly short period of time, the credit unions that most frequently proffer such opportunities often have membership restrictions such as having to work for a given employer or having to live within a certain geographic area.

Investing in CDs with the expectations of healthy yields in the current environment is simply unrealistic. However, an investor that can remain nimble by maintaining a high level of liquidity who is also willing to put in the time and effort needed to chase decent yield may find this pursuit sufficiently rewarding, particularly if they also value the security such investments offer.