Time for CDs?

Key takeaways

• With interest rates rising, CDs may offer higher yields than many higher-risk investments.
• Medium and longer-term CDs may offer opportunities to lock in those attractive yields for the future when interest rates are likely to eventually move lower.
• A ladder of CDs may offer both higher yield and greater access to your money than a single CD.
• CDs are insured by the FDIC.

What is a CD?

Do you have cash earning little to nothing? Perhaps you’ve been afraid to risk losing it in the stock market. Maybe you just got a bonus, sold property, or had some other windfall. If you have some cash that you're wondering what to do with, rising rates make now a great time to consider certificates of deposit (CDs), which are savings products with fixed interest rates issued by banks.

In the past, savers like you could earn significant income without much risk simply by buying CDs. That changed after the global financial crisis when the Federal Reserve drove interest rates to historic lows to revive the economy. Those super-low rates meant your money could either earn next to nothing in safe savings accounts, or you could risk the inevitable ups and downs of the stock market. All that has changed with the Fed’s new focus on fighting inflation by raising interest rates. While that’s been pummeling stock and bond markets, it’s created an exciting new opportunity for savers: to once again have the potential to earn attractive returns without taking much risk.

How does a CD work?

Typically, investments with higher risks also offer investors higher returns as compensation for taking those risks. That difference between the higher return potential of riskier investments and the lower returns of less risky ones is called a risk premium.

Now, though, many relatively low-risk CDs are offering yields that are higher than what riskier assets have delivered this year. While both the S&P 500 stock index and the Barclays US Aggregate Bond index are down by double digits, many CDs are offering yields above 4.5% as of February 15, 2023. 

And while stock and bond prices move up and down all the time as they trade on public exchanges, CD yields are fixed so you can know how much you'll earn for defined timed periods up to 20 years into the future. They are also FDIC-insured within limits.

When you buy a CD, you agree to leave your money in it for a specified period of time. In return, the bank agrees to pay you interest during the time you own the CD until it matures and you get the amount that you paid for it back. That period of time can be as short as 1 month and as long as 20 years.

Interest rates on CDs remain the same from the time you buy them until the time that they mature. That doesn't mean, though, that there aren't significant differences among various CDs in how much interest they pay.

Be careful with callable CDs. They often pay slightly higher yields but the issuer can redeem them prior to maturity and may pay you back less than the CD's full value. Issuers are more likely to call their CDs back when rates have fallen. This could mean that rates could well be lower when you look for new CDs than they were when you bought your original CD.

The interest rates that banks pay on CDs are influenced by interest rates set by the Federal Reserve, among other factors. With the Fed raising rates as it has been doing to help fight inflation, newly issued CDs may pay more than similar older ones issued by the same bank.

Another important influence on how much CDs pay is the length of time between when you purchase them and when they mature and return your purchase amount to you. Generally, CDs with longer maturities pay interest at higher rates than do those with shorter maturities.

Pros and cons of CDs

There are no "best" CDs. There are only those that best meet your needs. That means before you can take advantage of the benefits of CDs in a time of higher interest rates, you need to understand your personal and financial goals as well as your need for access to your cash.

Because CDs require you to give up access to your cash for a period of time in exchange for interest, you should only buy them with money that you are certain you won't need prior to the time when they mature. It may help to think of CDs as a middle ground between your longer-term investments and the cash that you may need for daily expenses or emergencies.

What is a CD ladder?

While CDs may currently require little trade-off between risk and reward, investing in them does require you to give up easy access to your cash in return for income. If you want to keep some of that liquidity while also maximizing yield, you may want to consider building what is known as a CD ladder. A ladder is an assortment of CDs with various maturity dates. It may include a mix of higher-yielding, longer-term CDs along with those that will mature sooner and return cash to you to use as you wish.

How to build a CD ladder

A typical ladder might include CDs that mature in 6 months, 12 months, 18 months, and 2 years. At 6 months, the first CD reaches maturity, the 12-month CD has 6 months remaining until it matures, and the 18-month CD has 12 months. At that time, you could then take the principal from the first maturing CD and use it to pay expenses, invest in stocks or bonds for the longer term, or extend your ladder by buying a new 2-year CD.

If you choose to extend your ladder beyond the maturity of the last CD in the bunch you originally bought, after a year, all the CDs with maturities of less than 2 years will have matured and been replaced by CDs that pay the full 2-year rate. A portion of your investment will also continue to mature every 6 months.

This ongoing maturing and reinvesting of the CDs in your ladder will mean that your CD portfolio will reflect changes in interest rates. If rates keep rising, your combined yield would rise over time as well. If rates fall, your yield would eventually decline, though you could choose to add longer-maturity, higher-yielding CDs if you believe lower rates are coming in the future. Spreading your CD investments across a variety of maturities may be a way to hedge against this interest-rate risk.

CD ladder considerations

If you're considering a ladder, you also need to consider how frequently you would like to see your CDs revert to cash. When a CD matures, it will give you an opportunity to reevaluate your cash needs and investment opportunities before reinvesting in a new CD.

It's also important to know that if your needs for cash change unexpectedly, you may need to pay a penalty to access your money before maturity and you might not get the price you want if you try to sell your CDs in the secondary market. You need to determine how much liquidity risk you can take to select the maturity of the final rung of your CD ladder.

Whether you choose bank, brokerage, individual, or laddered CDs, the opportunity to lock in attractive, reliable yields with the peace of mind of FDIC insurance begins with research. Find out more at Fidelity's fixed income research page.