For those like me who find it easiest to save by hiding cash from themselves.

Apr 21 '02 Write an essay on this topic.

The Bottom Line CD's will not make you rich, that's what the stock market is for. But they won't make you loose any sleep at night either.

I remember when I was a little kid. I looooved spending money. I'd get 10 dollars for my allowance, or 15-20 from the occasional odd jobs, and it was gone almost as quickly as I got it. When I was younger it was on girls, eating out, movies, etc... When I got my truck it was on a stereo, bed cover, and various other truck accessories. The idea of building a financial cushion was never very real for me until I found myself 3 years into college with a financial safety cushion of... hold on, lemme think here, do a few calculations...approximately zero dollars and zero cents. All incoming funds went right into a checking account and right back out to cover day to day expenses. Well, a better word might be extravagances.

A financial windfall or two in the last year has helped me to start building up the basis for a nice, sound investment portfolio when I leave college. It all began with a 500 dollar birthday check I got from my mother last year. Since I knew almost nothing about stocks and bonds at the time, I wanted to put it somewhere where it would be inconvenient but not impossible to get it back out while I looked at other options. Just like when I had to hide cash around my room and force myself to forget about it as a kid, I knew this money would have to go somewhere where I could put it out of my mind and separate it from my disposable income. A CD seemed like a good idea. I liked the guaranteed growth and protection of my principal, so I picked up a 14 month certificate of deposit with a 3.8% APY.

For those who may not know, certificates of deposit are issued by banks, brokerages, and other financial institutions. You deposit a set sum for a predetermined amount of time at whatever interest rate the bank is currently offering when you invest. The bank takes your money and in turn invests it in safe short term investments such as treasury bills. Terms may vary depending on the bank from 30 days to 5 years or more. At the end of the term, they pay you your interest out of the profits. As with savings accounts and money market accounts, they are federally insured for up to 100,000 dollars by the FDIC. So even if your bank goes belly-up right after you fork over your house down payment for safe keeping in a CD, you'll get your money back.

Would I do it again?

Probably not. One of the things that didn't occur to me then, but that does now, is that with today's interest rates, CD's only really make you a meaningful amount of money if you can afford to invest at least 1000. After 14 months with its 3.8 percent yield, my CD will earn me a whopping 22 dollars or so when all is said and done. Though there are banks out there offering CD's with 250 dollar or 500 dollar minimums, I think it's advisable to try to scrape together at least 1000 bucks to invest. After all, for smaller sums, the amount of interest you'd get back is really not worth the inconvenience of doing without your money for months at a time.

In what situations is it wise to buy a CD?

Got a sudden windfall but haven't really had the time to research investment options yet? Do you have specific amount of money sitting somewhere that you have earmarked for a major purchase such as a car or a house that you won't be buying for another few months? Maybe you just cashed in a stock and want to let your profits sit somewhere safe and earn decent interest while you figure out what you want to invest in next. CD's are not lucrative investments. They're more of what I might call a might as well type of an investment. If you're not touching the money for awhile anyway, but you don't want to risk it on the stock market because you'll need it fairly soon, you might as well stick it somewhere where it'll earn more interest than your typical savings account or money market account.

Are you one of those people who, like me, can't build up substantial cash savings without hiding money somewhere where it's kind of inconvenient to get at it, but not impossible? It is recommended that everyone build up at least 4-6 months of cash for living expenses so that in times of emergency such as layoff or severe injuries that keeps you out of work, you don't have to build up enormous credit card debt or cash in on lucrative stock investments with more years of growth left just to pay your bills. A CD is a good way to get started doing this, as you can redeem most CD's at any time for a 3 month interest penalty. You have more of an incentive to only access the money when absolutely necessary if you know taking it out early can cause you to miss out on interest payments.

Is there a good time to buy a CD?

When the Federal Reserve raises and lowers federal long term interest rates, which are basically the prices banks charge to loan each other money over night, those interest rates pull the yields of short term guaranteed investments such as certificates of deposits right along with them. If you keep an eye on current events to see what the Fed is doing, you can get reasonably accurate clues as to when may be the ideal time to lock in a CD. If it seems like rates may go down and you have a chance at a good rate, you may want to lock it in for a bit longer so you keep getting a good rate of return on your money while those who come to the party late have to settle for lower yields. Conversely, when the economy is in the process of recovering from a
slump and the Fed is considering raising rates to restrict growth to a reasonably steady pace, there's a good chance CD yields will go up soon. (Hint hint, nudge nudge: Keep a close look on CD rates toward the end of this summer!) In this case, you might want to get a shorter 3-6 month CD so that you can switch to the higher rates when they become available rather than being locked in at a low APR.

Are there CD related scams out there?

Of course. Life is full of scams. IF you see a CD advertised as being 'callable without interest penalties', take a very close look at the fine print. Calling a CD means redeeming it early. Some unscrupulous banks use this ruse to sucker unsuspecting investors into CD's with ridiculously long terms, as much as 60-72 months, because they know people would love the idea of being able to lock in a high interest rate on a CD for years at a time but
still get access to their money whenever they want without penalties. But the fact with CD's is that banks can usually call them at any time if they feel they can no longer pay you interest and simply give you your money back with interest earned to date and a pleasant "The Deal's off, have a nice day!" On the other hand, the investor is at a disadvantage, almost always unable to withdraw money without a 90 day interest penalty. These deceptive advertisements are often simply saying the CD is callable without mentioning that the bank is the only party that can call it. So just as with any other type of investment, beware of scams and look very skeptically at anything that sounds to good to be true.

Where is the best place to buy a CD?

In my experience, internet banks and smaller neighborhood banking institutions tend to offer the better interest rates on certificates of deposit and money market accounts. These places usually have lower overhead costs to pass on to customers than more established banks and more of a need to aggressively pursue new customers with attractive yields. Remember, you are the one who is locking away your cash for an extended period of time while the bank makes money on it. You deserve a reasonable yield as compensation for the inconvenience.

How about taxes?

Herein lies the pitfall, and the reason I probably won't hold my CD for very long. You must pay taxes on interest earned every year, regardless of whether you redeem or not. If you have a relatively small amount invested, this probably won't be that much of a problem for you. However, if you have several thousand dollars or more in a CD that you hold over a period of several years, you may end up paying a big tax bill every year for money you haven't touched yet. Personally, I think I'm starting to like government-issued I-bonds better for just this reason, as you can defer the taxes on interest earned until you redeem them. Uncle Sam can get his cut when I'm good and ready and not a minute before, thank you very much. CD's are ideal for short holding periods of up to a few years for money earmarked for specific plans, but I personally wouldn't consider them something worth holding for the long term.

As long as you have realistic expectations, CD's are a convenient way to let your excess cash earn some excess cash while you figure out what to buy or where to invest it. You can maximize your returns by shopping around for interest rates and timing your investment carefully.

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