If you have money you’re not earmarking for emergencies, then you may be inclined to invest it outside of a regular savings account. And in that regard, one option you have is to open a certificate of deposit, or CD.
The tricky thing, though, is that CDs come in a variety of terms. And you may not be sure which term is best. To figure out which direction to go, think about what your investment goals entail and what sort of milestone you’re investing for.
When you’re looking at a near-term goal
Generally speaking, you want the term of your CD to match your investment window more or less. So let’s say you’re trying to buy a home. You know you won’t be in a position to make an offer on one this year, but you think that with a nice savings boost, you may be able to make an offer next year.
In that case, a 1-year CD could be a good bet. If you go longer than that, you run the risk of not having access to your money when you need it. And while you could always cash out a CD before its maturity date, doing so generally means facing a costly penalty, the amount of which depends on your bank.
At Discover, for example, you’ll face a penalty of three months’ worth of interest for cashing out a CD early if its term is less than 12 months. For a CD term of 12 months to under 48 months, the penalty for cashing out early is six months of interest.
When your goal is far off
You may be investing for a milestone that’s way in the future, such as if you have a 10-year-old you eventually want to put through college. In that situation, you may want to opt for a longer-term CD.
In a typical interest rate environment, you’ll usually score a higher APY on a longer-term CD than a shorter-term one. That happens to not be the case today, though, because banks are well aware that the Federal Reserve is likely to start cutting interest rates at some point this year.
Because of this, you’re likely to find a better CD rate on a 12-month term than, say, a 60-month term. However, if you want a guaranteed return for longer, then for a far-off milestone, a 60-month term may be a good bet.
At Discover, right now, you’ll get a 5.20% APY on a 12-month CD and a 4% APY on a 60-month CD. The 5-year CD might seem like a bad deal, but remember, you’re guaranteed that rate for 60 months.
In a year from now, the best CD rate available across all terms might be 3.50%. So in that situation, earning 4% for five whole years means you may be coming out ahead financially.
Don’t rule out a good old fashioned brokerage account
Another thing you may want to do if you’re working toward a longer-term goal is split your money between a CD and a brokerage account. That way, you can potentially get the best of both worlds.
CDs offer no risk of losing principal as long as you bank at an institution that’s FDIC insured and you limit your deposit to $250,000. When you invest in stocks and other assets in a brokerage account, you could lose money.
However, there’s the potential to earn a much higher return in a brokerage account over time than with a CD. The stock market’s average yearly return over the past five decades, for example, has been 10%. So for a far-off goal, one thing you may want to do is split your money between a 5-year CD and a portfolio of stocks.
You’ll get a guaranteed 4% return (assuming you opt for the 5-year CD referenced above) on your CD, and an unknown return on your remaining money. But that unknown return could easily be 10% or more.
All told, the right CD term could help you meet your savings and investment goals. Consider the window you’re working with, but also consider putting money into CDs as well as other assets to increase your chances of walking away with really solid returns.
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