I’m a Banking Expert: Here’s How Much Money You Should Put in a CD
Written by
Martin Dasko
Edited by
Molly Sullivan
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A certificate of deposit, or CD, is a specific type of savings account where you lock up your money for a specific period of time without the ability to withdraw anything until the agreed-upon maturity date. A CD varies from a traditional savings account since you can’t access the lump sum you invested for the entire term unless you want to risk paying a penalty. Since a CD isn’t as liquid as a savings account, you may be confused about how much money you should invest in one of these.
How Much Should You Put in a CD?
The amount you put in a CD will depend on your financial goals and the timeline. The general rule of thumb is to select a maturity date for your CD based on when you want to access the funds.
“A CD with a high interest rate is a great place to stash money that you’re saving for a goal, such as a downpayment on a house or major purchase,” said Scott Lieberman, founder of Touchdown Money.
“Unlike bonds and commons stocks, typically considered longer-term investments, CDs may be purchased with securities that match investors’ short-term needs,” said Robert R. Johnson, PhD, CFA, CAIA, professor of finance, Heider College of Business, Creighton University. “For instance, if a parent wants to invest to fund a child’s college education, and the child is entering college one year from today, the individual may want to purchase four CDs, maturing every year for the next four years. The amount of the CD would be equal to the amounts expected to be needed for tuition. And this is entirely goal-dependent.”
CD Investments Are Based on Your Goals
The common answer is that the amount you put into a CD depends on your financial goals and unique situation. There isn’t a one-size-fits-all solution when it comes to CDs. However, you’ll want to utilize a CD for your funds if you have a specific goal with a timeline. For example, you wouldn’t leave your retirement funds or an emergency fund in a CD, but if you’re saving for a down payment or a new car, you would consider a CD.
Should You Leave Your Funds in a Savings Account or a CD?
Before you place any funds into a CD, you want to ensure you have a healthy emergency fund to help prepare yourself for whatever life throws at you.
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“It’s smart to have 3 to 6 months’ worth of expenses in an emergency fund in a savings account that you can easily access,” Lieberman said. “Then, contribute to your retirement fund in a tax-advantaged account such as an IRA or 401(k) or 403(b). Now look at the money you have left. This is money you can consider putting into a CD.”
Lieberman added, “A CD offers a super safe way for your money to earn interest for you completely passively.”
When you place your funds in a CD, you know that your return will be guaranteed, and you won’t have to worry about stock market fluctuations.
CD Security
“A CD is FDIC-insured, so you’ll never lose the money you deposit,” Lieberman said.
The CDs offered by banks are insured for up to $250,000 by the FDIC. The CDs offered by credit unions are insured for up to $250,000 by the NCUA.
Drawbacks of Investing In a CD
“The drawback to a CD is if you need to take the money out before the agreed-upon term, you’ll pay a penalty,” Lieberman said.
When investing in a CD, you have to ensure that you won’t need to access the funds until maturity.
“Generally speaking, if one has a long-term time horizon and wants to build wealth, one is better off investing in a diversified portfolio of common stocks than investing in CDs,” Jonhson said.
It’s worth pointing out that you can find higher returns for your money if you’re willing to take on additional risks.
Johnson elaborated on another risk of investing in CDs: “Reinvestment risk is a major concern for CD investors. That is, reinvestment risk is the risk that rates are substantially lower when the CD matures. The CD investor is faced with reinvesting the CD proceeds (both interest payments and principal when the CD matures) at a low interest rate.”
Considerations for Investing In CDs
“In my opinion, CDs are better vehicles for protecting wealth than for building wealth,” Johnson said. “The rate of return on CDs is lower than rates typically available on higher-risk alternatives. For example, CDs typically pay a rate of interest below that paid on long-term government bonds. A greater spread would be available from an investment in corporate bonds, but there would also be greater risk.”
It’s also worth mentioning that all income earned from CDs is fully taxable and subject to ordinary income taxes. The penalties that investors pay for redeeming CDs before the maturity date are deductible for federal income tax purposes.
Setting Up a CD Ladder
“An option to mitigate reinvestment risk is to create a laddered CD portfolio,” Johnson said.
One strategy that investors use with CDs to maximize their returns is to set up a ladder. Johnson shared the logic behind this:
“In a laddered portfolio, an investor invests in an assortment of CDs with staggered maturities. For example, the investor can structure a portfolio where ten percent of all the CDs mature each year. The CDs would not all mature in the same interest rate environment. A CD ladder reduces interest rate risk by staggering maturities among several bonds, each of which represents a rung on the ladder. For a long-term investor, that ends up being similar to a dollar cost-averaging strategy.”
CD Ladders Can Help With Future Income
“A greater reason to use a CD ladder is that it enables the investor to match cash flows with planned expenditures,” Johnson said. “CD ladders can also work for unplanned expenses. For example, if an investor loses her job, maturing CDs can be used to supplement lost income.”
Closing Thoughts
If you have long-term financial goals like saving up for your dream home or paying for your wedding, you’ll want to consider investing your funds in a CD with a maturity date that matches your timeline. As always, we recommend that you take into consideration your own unique financial situation when making a decision on how to invest your money.
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