If you’re looking for a way to generate more interest on your money than what a regular savings account provides, then a CD could be a good bet. Since CDs require you to tie up your money for a preset period and savings accounts don’t, CD rates are typically higher than savings account rates. CD rates are also guaranteed for the duration of their respective terms, whereas with a savings account, the interest rate you’re entitled to could change.
While it’s easy to see the appeal of CDs, you should know that by opening one, you’re taking on a risk. And it may not be the risk you’re thinking of.
When you lose out on a chance to earn more
It’s common for CDs to impose a penalty for cashing out your money early. The extent of that penalty will depend on your bank and your CD’s term, but as an example, some banks charge three months of interest for CDs with a duration of 12 months or less.
You might think that opening a CD is risky because of this penalty. But there’s another risk you should be mindful of — interest rate risk. And it’s something to be concerned about when you’re looking at longer-term CDs in particular.
When you open a CD, you’re locking into a specific interest rate. But if rates rise during your CD’s term, you end up losing out on the potential to earn more interest on your money.
Now, the risk of that happening isn’t as great with a 6-month CD. But if you’re thinking of opening a 24-month CD or longer, it’s something to be mindful of.
What if you put money into a 24-month CD with an interest rate of 4.00%, but a few months later, that rate rises to 4.50%? Suddenly, you’re stuck with a lower interest rate on your money for months on end.
Pay attention to market conditions
Without a crystal ball, it’s impossible to predict exactly what CD rates will look like at any given point in time. But one thing you should do is pay attention to the movement of the federal funds rate, which is the rate the Federal Reserve oversees.
When we say “the Fed raised interest rates,” we’re talking about the federal funds rate, which is the rate banks charge each other for overnight borrowing. When the Fed raises interest rates, CDs tend to start paying more. When the Fed cuts interest rates, CD rates tend to follow suit. So simply following the news and paying attention to what the Fed does or is expected to do could help you make a smart decision with your CDs.
For example, this year, the Fed is expected to cut interest rates in response to cooling inflation. Now’s probably a good time to lock in a longer-term CD, since CD rates are among the highest we’ve seen in many years. Chances are, if you open a 24-month CD tomorrow, in six months’ time, the rate on that product will be lower.
However, if you intend to continue to open CDs, pay attention to what the Fed is doing. If you start to hear rumblings about interest rate hikes, perhaps wait on opening a longer-term CD to see if rates become more favorable eight or 10 weeks down the line.
Another thing it pays to do is ladder your CDs so you have money freeing up at different intervals. This could not only reduce your chances of facing an early withdrawal penalty, but also help you avoid losing out when higher interest rates come down the pike.
During periods when the Fed seems to be in a holding pattern as far as interest rates are concerned, it could pay to stick to shorter-term CDs of one year or less and maintain a rotating ladder so you get the best of both worlds — a higher interest rate than what a savings account will pay, and flexibility with your money and the chance to jump on higher rates should they become available.
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