With a Certificate of Deposit (CD), the maturity date is fixed as is the interest rate.
CDs do offer a financial advantage in terms of assured returns and security via the FDIC net. However, you can’t use the moneys before maturity. In case you opt for an early withdrawal, an early withdrawal penalty is levied.
As an investor, your goal is to maximise returns, taking due factoring for liquidity as well. Based on your estimated cash needs, you can choose between short term and long term CDs. CD rates vary depending on the duration. A long term CD will offer you the highest interest rate, while a short term CD will give you a comparatively lower rates of return.
- Short Term or Long term
The choice is yours, depending on your need for liquidity. Since early withdrawal attracts a penalty, it is best to assess your future cash needs before you make a CD investment.
- For short term goals like paying the downpayment for a home mortgage, buying a car or paying for a holiday, you can choose to invest in a short term CD.
- However, if you need a large sum for important commitments like your child’s education or paying off a mortgage, a long term CD works best—it offers higher returns.
- Also, by choosing to reinvest the interest on a long term CD, you enjoy the benefit of compounding. This way, you earn a substantial interest. It is to be noted that CD interest is compounded monthly.
- The high return on a long term CD is shadowed by the risk. In the long term, interest fluctuations are pronounced. Though the interest rate is fixed at the time of investment, the real return from the investment (say after 5 years) would turn out to be less than your principal investment.
How To Balance Risk and Return
- Laddering your CD investment is the best way out to minimise the risk and maximise returns. When your ladder CDs, you open multiple CDs of varying tenures having staggering maturity dates.
Example: instead of having a consolidate CD of one large amount, it is recommended to have smaller denomination CDs spread over years, say one year, two years and so on. This way you can ensure liquidity by utilising the CDs that have matured.
- Laddering ensures that you will not have to incur early withdrawal penalty. The short term CDs keep your liquidity intact, while the long term CDs earn you high interest rates.
- You can also adopt the barbell strategy. Under this kind of CD structuring, you invest only in short term and long term CDs. You don’t invest in intermediate term CDs. This strategy helps to increase your overall yield.
- Choosing the right CD is based on your saving goals. A fine balance between liquidity and returns can help your money to grow optimally.