Written By
Matt Crabtree
Certificates of deposit (CDs) give risk-averse investors the ability to watch their savings grow with little risk. Numerous banking institutions offer high yields on their CDs and, depending on your goals, you can develop strategies for investing in one or several certificates with several term lengths.
Before investing, though, it is essential to learn about CDs pros and cons and know what to expect from such an investment.
At a Glance: Pros and Cons of CD Investing
Essentially, certificates of deposits are savings accounts that hold a fixed amount of money for a fixed period of time with the promise of a guaranteed rate of return.
In the UK, CDs are governed by the Financial Services and Markets Act 2000 and may be traded.
Pros
✔️ Guaranteed returns. Unlike traditional trading, which comes with risks, certificates of deposit offer predictability. Interest rates are a lot lower than trading ROI, but they are typically fixed for the entire term. Thus, it is easy to predict how much you’ll save by the end of the term.
✔️ Safety. Beyond guaranteed returns, CDs are the safest places to keep your savings. That’s because money held in CDs is insured, and you’re covered in case the banking institution is shut down or goes out of business.
✔️ CD laddering offers access to liquidity. When opening a CD, you agree to keep the money in the bank for a fixed amount of time. Typically, you can’t access those funds without paying hefty fees. CD laddering is a strategy investors use to ensure access to liquidity. To do this, they open various CDs with different interest rates and varying terms of maturity. At any given time, you’ll have a CD maturing and another or others that have matured and allow you to roll the money out.
✔️ Higher rates than savings accounts. Risk-averse people might be afraid of investing and keep their funds in standard savings accounts. Banks offer interest on money held in these accounts, but the rates are usually lower compared to CDs. If you plan to keep your savings in the bank for a set period, a CD could be a better option.
✔️ No account maintenance fees. With standard or savings accounts, your bank might charge monthly maintenance fees that can easily eat out any interest you might have earned. This is not the case with CDs. These accounts typically don’t charge maintenance fees.
Cons
❌️ Low returns. CDs offer stable returns and security that other investment types can’t offer, but interest rates are rather low. Where you could earn thousands from investing in stocks, CDs only yield a couple of hundred pounds on average over five years.
❌️ Inflation risk. Certificates of deposit are considered risk-free because of the guaranteed returns. With fixed interests over a set period, you can figure out how much your savings will yield in the term. However, if the inflation outpaces the rate or return, your savings won’t stretch too far when it’s time to spend.
❌️ Can’t be used as emergency funds. Unlike savings accounts that give holders the ability to withdraw money without incurring penalties, a CD requires you to keep the funds in place until it matures. For this reason, CDs don’t double as emergency funds. While you can withdraw money before the term, expect to pay expensive fees.
❌️ Interest rate risk. When signing up for a CD, you agree with a fixed interest rate for the whole term. However, if interest rates rise right after you sign on the dotted line, you won’t be able to take advantage of them unless you open a new CD.
What are CDs?
A certificate of deposit is a particular type of savings account that pays a fixed rate of interest over a specific period of time.
In this aspect, CDs are similar to time deposits, as the money put into the account becomes unavailable until the CD matures.
Standard CDs are available in terms ranging from six or fewer months to five years, even though different terms and conditions may be available from different banking institutions. Longer-term certificates of deposit usually pay more compared to short-term solutions.
Different Types of CDs
Most banking institutions offer standard (regular) CDs to savers. Regular certificates of deposit are the ones defined above — fixed interest rate over a fixed period of time.
To address changing markets and demands, however, banks now offer a range of CDs:
- No-penalty CDs. Also called liquid certificates of deposit, no-penalty CDs allow you to withdraw the funds early without penalty. However, they pay lower interest rates than regular CDs.
- Variable CDs. These certificates of deposit come with variable interest rates throughout the life of the CD. Your savings can return higher yields if interest rates go up, but you could also lose interest if the rates drop.
- Bump up CDs. Offer a fixed interest rate initially, but allow you to bump up the rate once during the life of the CD. This option can be helpful if you think interest rates may go up in future, but banks usually offer lower interest rates initially. You also may be unable to bump up the rate if it doesn’t go up as much as you expect.
- High-yield CDs. Similar to high-yield savings accounts, these CDs promise higher APYs, but they may require you to commit to longer terms or make a bigger initial deposit.
- Jumbo CDs. These CDs are very similar to the regular kind, but ask for bigger initial deposits. To put things into perspective, most banking institutions ask for an initial deposit of around £500 to open a CD account. The initial deposit for jumbo CDs can be as high as £100,000. On the bright side, you’ll earn higher interest.
- Add-on CDs. This special type of certificates of deposit give holders the ability to add more money into the account throughout the CD’s life. Opting for such a CD is ideal if you don’t want to invest all your savings upfront, but they may come with specific rules regarding the minimum amount of any additional deposit.
- Foreign currency CDs. If you don’t mind investing in Euros or U.S. dollars rather than sterling pounds, a foreign currency CD usually offers higher yields. However, you risk losing money when converting the currency back to sterling pounds for spending.
- Brokered CDs. These CDs are purchased from a brokerage firm or financial advisor rather than a bank. They usually have longer terms — up to 30 years in some cases — but earn higher yields compared to bank CDs. Brokered CDs are also easy to trade on secondary markets.
What to Know Before Investing?
The most important thing before putting your money into a CD is to determine your goals. Analyse your financial situation and decide what it is you want to achieve with your investment.
Set up an emergency fund and make sure you have enough money in it before setting up a CD. Keep in mind that you won’t be able to access your CD money without paying a penalty until the term — unless you opt for a no-penalty certificate.
Determining your goals can also help you pick the right CD term.
Certificate of deposit terms can vary from six months to up to five or ten years in most cases. Brokerage firms may have even longer terms, up to 30 years.
Before investing, also make sure that you understand the pros, cons, and limitations of CDs. While the investment is nearly risk free, it doesn’t have the high yields expected from riskier options like stocks or ETFs.
CDs Investing Guide
Investing in CDs can seem as easy as opening a savings account — and in certain aspects, it is. However, there are a few things to consider before signing on the dotted line.
Step 1 — Decide the right investing strategy
Setting up a CD account is similar to opening a current or savings account. However, there are various strategies that can help you maximise returns.
- CD ladders: If you don’t want to invest in a single certificate, split your money into equal amounts and deposit the sums into different CDs. You should choose a different term for each CD so that you can benefit from different interest rates. Once the term is up for each initial certificate, reinvest the amount into a long-term CD with a duration of at least five years.
- CD barbells: This strategy is used to invest the funds in short-term CDs while waiting for long-term interest rates to rise. Money can be split between different CDs with initial terms between six and 12 months, and reinvested into a long-term CD once the interest rates have gone up. The risk is that you might miss out on higher rates if the market is volatile and all your funds are stuck in short-term CDs when the rates go up.
- CD bullets: The opposite of ladders, CD bullets start with a long-term CD, then new CDs are set up at regular intervals (one or two years) with a maturity date that coincides to that of the first CD. It is an excellent strategy for retirement if you want to keep safe any capital gains obtained from other investments up until you retire.
Step 2 — Consider the minimum deposit you can afford
For each certificate of deposit, consider the minimum deposit you can afford. This step is crucial as different banking institutions have different regulations and requirements regarding the minimum deposit.
Most banks require a minimum deposit of £500, making it easy for most people to invest in CDs. However, specialised financial institutions may ask for jumbo deposits of £100,000 or more. Brokerage firms may also require higher deposits.
Step 3 — Decide the right term
As explained, CDs may need anywhere from six months to 30 years to mature. Analysing your financial situation and establishing short, medium, and long-term goals can help you decide which is the right term for you.
If you have some savings but expect to need liquidity in the short or mid-term, opt for a short or mid-term CD with a maturation up to five years. A 10-year CD could help you earn more interest if you’re saving for a down payment on real estate, for instance.
Long-term CDs are ideal if you have a separate emergency fund and don’t expect to need liquidity until retirement. Terms in this case can be up to 20 or 30 years.
Step 4 — Take the best CD type for you
Most banking institutions offer regular CDs in addition to savings and ISA accounts. However, a no-penalty or variable CD might be better in certain circ*mstances.
If you don’t have clear financial goals and don’t know what type of certificate to choose, you should consult an independent financial adviser.
Step 5 — Shop for the best rates
CDs have low returns compared to other investment types, so choosing the best provider is crucial. Shop around and compare interest rates from various banking institutions.
Read the terms and conditions for each interesting offer (including the fine print) to make sure the offer you pick is right for you.
Step 6 — Consider early withdrawal penalty fees
When shopping around, also consider early withdrawal penalties in addition to the interest rate. These fees apply to almost all CD types, except for no-penalty certificates.
While you may be tempted to ignore a high early withdrawal penalty due to a better interest rate, keep in mind that the unexpected can happen and you might have to access the funds in the CD even if you have an emergency fund set aside.
Some banks charge astonishing penalty fees that can easily exceed any interest you might have earned over the CD’s life.
Step 7 — Establish your CD
The last step is to schedule an appointment with your bank or broker and set up the CD. After that, you can sit back and wait for it to mature.
Top CDs Investing Banks
1. Bank of Cyprus
Ideal for young adults and anyone with little savings, the Bank of Cyprus offers a variety of fixed term savings accounts.
You can set up a CD with an initial investment of £30 for most accounts and a maximum deposit limit of £500,000. Fixed deposit accounts vary from traditional (fixed interest rate for the entire deposit, if the fixed term is respected) to no-penalty and even options with advance or monthly payment of interest.
Visit Bank of Cyprus
Terms vary from one to 18 months, depending on the type of account chosen.
2. Hodge Bank
Hodge Bank isn’t as flexible as the Bank of Cyprus in terms of account flexibility, but you can earn an interest rate up to 3.65% AER.
Maturity terms vary from one to five years, the interest rate increasing for longer terms.
Hodge Bank requires a minimum deposit of £1,000 and funds are protected by the Financial Service Compensation Scheme up to a total of £85,000.
Visit Hodge Bank
In addition to fixed rate bonds, Hodge Bank also offers cash ISA accounts.
Summary
Certificates of deposit are fixed-term deposits that earn you interest at maturity. They won’t have the same returns as security investments, but could be a better option for risk-averse individuals and investors who want to build a low-risk portfolio.
Considering your short and long-term financial goals is the best way to decide whether this investment type is right for you.
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