Investing in certificates of deposit (CDs) starts with understanding what a CD is and how it works. A CD can generally be described as a type of federally insured savings account. Whereas traditional savings accounts enable depositors to access their money whenever they want it (albeit only six times a month), CDs generally require investors to keep their money invested for a specific period of time in exchange for predetermined monthly interest payments.

The original investment is returned in a lump sum on what is referred to as the CD's maturity date. While many certificates of deposit have no minimum investment requirement, some do—of $500, $1,000, or more. CDs are commonly purchased through banks, credit unions or similar financial institutions. When CDs are purchased through a brokerage firm, they are referred to as brokered CDs.

Key Takeaways

  • A CD is a type of federally insured savings account in which you invest funds for a specified period of time in exchange for predetermined monthly Interest payments.
  • Accessing funds invested in a CD prior to the maturity date, even when allowed, often results in an early withdrawal penalty.
  • One way to address early withdrawal penalties in a portfolio is to create a CD ladder, which involves investing equal sums of money in multiple CDs, each with a different maturity date.
  • Different types of CDs may fit investors' needs, from bear and bull CDs to callable, variable-rate, and zero-coupon CDs, among others.

Benefits of CDs

CDs offer investors a safe place to earn a predictable stream of income. The safety comes from the Federal Deposit Insurance Corporation (FDIC), a government agency that protects depositors against bank failure, which provides up to $250,000 of insurance per depositor in the event of bank failure. (Investors with more than $250,000 should make deposits at multiple banks to make sure all of their assets are protected by the FDIC.) The National Credit Union Administration (NCUA) provides the same level of insurance for CDs purchased through a credit union, which are known as share certificates.

CDs typically offer higher interest rates than traditional savings accounts as compensation for reduced flexibility in withdrawal options. Longer maturity dates tend to pay higher rates of interest than shorter maturities, so investors with long time horizons have an even greater incentive to choose a CD instead of a savings account.  

CDs are sometimes compared to annuities because both offer income streams and insurance protection and are available in similar variations. While annuities often pay higher rates of interest, CDs offer greater flexibility, lower cost, FDIC insurance (versus private insurance), and are less complex than annuities, making them attractive to conservative investors.

Buy One and Hold: Risks and Limitations

The simplest approach to investing in CDs is to buy one and hold it until it matures. There are several risks and limitations with this strategy. The first is that interest rates may fall over time, so when the CD reaches maturity and the proceeds are ready to be reinvested into another CD, the next investment will offer a lower interest rate. Alternatively, if interest rates rise, you can lose out on a higher rate if your CD hasn’t yet reached maturity.

Another risk is tied to the fact that the money invested in a CD is usually unavailable to spend until the CD matures. In cases where it can be accessed prior to the maturity date, taking the money out early often results in a financial penalty. Penalties can vary widely, according to a 2019 study by DepositAccounts.com, with some providers wiping out 30 days’ worth of interest on a one-year CD and others taking the entire year’s worth.

Long-term CDs, such as those with five-year maturity rates, come with a similarly notable range of penalties, from 90 days at the low end to 730 days at the high end. Brick-and-mortar banks tend to have lower penalties than internet banks, but regardless of institution, investors need to shop carefully and pay attention to the details.

Check your CD terms carefully: Many banks allow accrued interest to be withdrawn before maturity without a penalty.

Source: DepositAccounts.com Study.

Portfolio Construction

Early withdrawal penalties can present both short-term and long-term challenges with regard to an investor’s ability to address unplanned spending needs and financial developments that require an adjustment to long-term plans. Fortunately, there are investment strategies available to help address these challenges.

CD ladders

One option is known as a CD ladder. To construct a laddered portfolio, equal sums of money are invested into multiple CDs, each with a different maturity date. For example, a $100,000 investment could be spread out over 10 years as follows:

Amount CD Maturity
$10,000     1 year
$10,000     2 years
$10,000     3 years
$10,000     4 years
$10,000     5 years
$10,000     6 years
$10,000     7 years
$10,000     8 years
$10,000     9 years
$10,000     10 years

Each maturity date can be thought of as one rung on the ladder. Using this strategy provides defined dates on which each CD will mature and a specific amount of money that an investor can plan to have available on each date. The money can be used to address spending needs or, if it’s not needed, can be used to invest in a new 10-year CD, thereby extending the ladder.

This strategy also provides a measure of flexibility to deal with changing interest rates. If rates have risen, extending the ladder provides access to the higher rates. If rates have fallen, maturing assets can be moved away from CDs and into better paying investments even as assets that have yet to mature benefit from having been invested at a time when interest rates were higher.

There are other ways to structure a CD ladder. For example:

The barbell strategy

If cash will be needed for shorter-term spending needs, such as in a year or two, and then again at a predetermined longer-term period, a barbell strategy can be employed. This involves putting a specific amount of money into a shorter-term CD and a second amount into a longer-term CD. Think of it as a ladder without the middle rungs.

The bullet strategy

While both of the previous strategies involve investing a sum of money all at once into CDs with varying maturity periods, there’s another strategy for investing over time for a long-term goal. Known as a bullet, the strategy is like buying one rung of a ladder each year, except instead of extending the ladder with each new rung, all rungs mature at the same time.

If cash is needed for a large expense 10 years from now, for example, incoming cash flows can be used to purchase a new CD each year for 10 years. In this case, CD1 matures in 10 years; CD2, bought a year later, matures in nine years; and so on. When all of the CDs mature at the same time, the money can be used for the designated purpose.

Variations

Traditional CDs are purchased and then held to maturity to avoid early withdrawal penalties. Because this model doesn’t fit every investor’s needs, there are a wide variety of innovative alternatives ranging from simple to sophisticated. Some of the more notable variations include:

Bear CD: Designed for sophisticated investors, bear CDs increase the rate of interest that they pay when the value of a stated benchmark index falls. They are typically purchased by investors seeking to hedge against potential losses in other positions.

Bull CD: Bull CDs work in a way that's opposite to bear CDs, as they increase the rate of interest that they pay when the value of a stated benchmark index increases.

Bump-up CD: Bump-up CDs provide an opportunity for investors to take advantage of rising interest rates by increasing the rate of interest paid by the CD. Shorter-term CDs are typically limited to a single increase while long-term CD may offer multiple increases.

Callable CD: Callable certificates of deposit can be redeemed by the issuer prior to the stated maturity date, usually within a given time frame and at a preset call price.

Jumbo CD: Jumbo CDs require a minimum investment of $100,000 but are often issued to institutional investors with a million or more dollars to invest. The higher minimum investment is accompanied by a higher interest rate. Maturity dates vary. While they cannot be redeemed prior to maturity, they can be sold to other investors. Jumbo CDs are also known as negotiable certificates of deposit. 

Uninsured CD: Uninsured CDs are not guaranteed by the FDIC or any other entity. In exchange for the risk of having no insurance, they offer higher interest rates.

Variable-rate CD: Variable-rate CDs pay out interest at a rate that can go up or down based on the movement in the rate of a benchmark index.

Yankee CD: Yankee CDs are issued by foreign banks. They are denominated in U.S. dollars but are not insured by the FDIC.

Zero-coupon CD: Zero-coupon CDs are purchased at a discount to their face value. Rather than make periodic interest payments, they return the amount of the original investment and all interest due in a single lump-sum payment at maturity.

CDs Are Safe…but Pay Attention

CDs are typically viewed as a “set it and forget” investment, meaning that there is no ongoing monitoring required. Investors simply hand over their money, sit back, and collect interest, safe in the knowledge that the FDIC or NCUA (in most cases) is providing protection against losses.

While that is generally true, this is where a bit of complacency can slip in. When a CD reaches its maturity date, there is typically a short window of time (often seven days) during which investors can withdraw their money before it is automatically reinvested in a new CD with a maturity length that matches the one that just matured.

If you don’t need the money for another purpose, it may be fine to let the automatic reinvestment occur. But keep in mind the financial penalty that may result from withdrawing your money prior to the maturity date, so letting automatic reinvestment occur could cost you some money. It's also worth your while to compare interest rates, which can range widely across institutions, both brick and mortar and online. Like any investment, CDs should be carefully reviewed to determine their suitability prior to investment and monitored periodically once the money is put to work.