Maximize Your Earnings and Balance Risk and Reward
When you buy a CD, you lend the bank a lump sum of money for a certain period of time in return for an agreed-upon interest rate. If you withdraw all or some of your money before the maturity date, you'll usually incur a penalty. The interest rate on most CDs is guaranteed, but some have adjustable rates that fluctuate with an index tied to some portion of the stock market.
Be cautious about CDs offered by brokerages. Only experienced investors who understand the special risks of these types of CDs should invest in them. Bank CDs, on the other hand, are insured by Federal Depositors Insurance Corporation (FDIC) as long as the bank you buy the CD from is FDIC-insured and the total of all your deposits at that bank doesn't exceed $100,000.
The terms of a CD can range from one month to five years or more, so how do you decide whether to buy a short-term or long-term CD? Consider the interest rate climate. Are rates extremely low? If so, go for the shorter term so your money is not tied up if rates rise in the near term. There's little more frustrating than collecting 2% interest on a long-term CD when market rates increase and current CDs are paying 6%.
Are rates high or expected to drop? Go for the longer term to lock-in the high rate for as long as possible. Your goal is to try to balance risk (the chance that your money will be tied up at a lower interest rate than what's available elsewhere) and reward (the longer the term, the higher the interest rate).
The Internet has made finding the best CD rates extremely simple. Sites like BankRate Monitor offer online tools that allow you to quickly find the best deals available. Click on the CD/Savings link on the left side of BankRate's home page. This will take you to the CD rate page, where you can indicate whether you want to search for the best rate or select a particular state. Don't limit yourself to CDs from local banks--the rates may be considerably higher outside your state or from on online bank. You can set up your CD online or by phone.
If you have a chunk of cash that you've been holding onto, waiting for the economy to improve and the stock market to settle down, laddering CDs may be a good option. The beauty of a CD ladder is that you lower your risk and increase your return without losing access to at least some of your cash.
You start the ladder by buying several CDs at one time but with different maturity dates, for example, one year, two year, three year, four year, and five year CDs. Every year one of your CDs will mature and you can roll it over into a new CD with a longer term (if rates are high) and higher rate.
For example, assume you have $10,000 sitting in a passbook savings or money market account and you are chafing at the bit every time you receive your bank statement and see the paltry interest your funds are earning. You research CD rates and identify the bank with the best deals that meet your criteria. Then you purchase five CDs: CD #1 for $2,000 for a one-year term, CD #2 for $2,000 for a two-year term, CD #3 for $2,000 for a three-year term, CD #4 for $2,000 for a four-year term; and CD #5 for $2,000 for a five-year term.
Each CD is like a rung on a ladder. When the one-year CD matures, roll it over into a new CD for five years (or whatever term you decide to use for your ladder). When the two-year CD matures, roll it over into a new CD for five years. When the three-year CD matures, roll it over into a new CD for five years, etc. You can choose a shorter or longer term when you begin the ladder, but the key is to use the same term for each one once you start rolling them over at maturity. At the end of five years you'll have five CDs with one maturing every year after that, so you'll never have all of your money tied up long-term or at lower than market interest rates.
CD laddering is a smart way to protect yourself against fluctuations in interest rates while giving you the security of knowing that you will be able to access at least some of your money within a relatively short time frame.
