We run through Certificates of Deposits with a one-year term length in this article, and we explain all the facets of this savings product, including what CDs are and how to choose the best rates that suit your investment objective. We also cover 1-year CDs, pros and cons, as well as a step-by-step guide for opening one.
A Certificate of Deposit or CD is a financial product offered by commercial banks and certain credit unions. It is generally considered a safe investment because it is insured by the Federal Deposit Insurance Corporation (FDIC) and the National Credit Union Administration (NCUA) for up to $250,000. CDs allow you to save money similar to what you do with a regular savings account but with a few key differences. For example, with a CD, you can’t touch your funds for a specified period, but you are afforded higher interest rates.
This makes CDs comparable to bonds, which makes them great vehicles to park your money either as you gear up for a future expenditure or to have some modest but steady returns in your portfolio.
The rates you get with CDs are calculated using the compound interest formula. This essentially means that the interest payments are not based on the principal. Instead, each time your CD is due for an interest payment, the principal plus all the accumulated earnings are multiplied by the rate of the CD.
Here is the formula:
Final Amount = Principal (1+Rate) Term
So, let’s say you have $10,000 locked in with a CD for five years with a 3% rate.
$11,592.74 = $10,000 (1 + 0.03)^5.
By the time the five years are up, you would have $11,592.74 if rates are compounded annually.
To choose the right CD rates for you, you first need to know what affects CD rates. CD rates vary between banks and credit institutions, and they change periodically. It can also be influenced by your deposit amount, the type of CD you choose, the CD’s term length, and to a larger degree, economic factors.
Let’s breakdown the factors and how they affect rates:
Bank or Credit Union: Banks and other credit institutions will not have uniform rates, and it all depends on their objectives. To bring more customers and increase deposits, banks can increase their CD rates. On the other hand, they can keep it low or even reduce it if they don’t want more deposits coming in since CDs are usually categorized as liabilities in a bank’s balance sheet.
Deposit Amounts: Jumbo CDs are those with more than $100,000 deposited. This has slightly bumped up rates compared to CDs with less than $100,000.
Type of CD: CDs also have different types. Fixed-rate CDs, for example, will have the same rate until the CD’s maturity date. Another kind of CD, which is called a variable-rate CD, will have varying rates that follow Fed rates. And then, there is also an adjustable-rate CD wherein you have the option to recalibrate the rates but only for a limited amount of time.
Term Length: CD rates are also affected by the term length of the savings product. Long-term CDs will have higher rates compared to short-term CDs.
Economic factors affect rates across the nation through a benchmark interest rate like the Fed funds rate. The Fed adjusts its rates in response to the current economic situation of the US. For instance, what caused the CD rates today to be at rock bottom levels is the Fed reducing the Federal funds rate last year to shore up the economy from getting severely hampered by the COVID-19 induced global recession.
By knowing all those that influence CD rates, you’d be able to decide how you position your funds in this investment vehicle. You can decide if the amount you deposit, the term length you choose, and the type of CD will get the best yield that meets your investment objectives.
As mentioned, one of the factors affecting CD rates is the term length. And usually, CDs can be classified into long-term and short-term, and this is defined by how long you’ll hold the CD until its maturity date.
A short-term CD has a term length of not more than a year, and the shortest term can be from one to three months. These, of course, offer lower rates compared to the long-term ones. For example, the current national average for a 6-month non-jumbo CD as of January 2021 is 0.10%
Now, when it comes to purpose, CDs with short-term lengths are an excellent way to set aside funds for future expenses while earning a return at the same time. Short-term CDs are great for temporary financial obligations like weddings or vacation trips.
Conversely, a long-term CD’s has a duration that extends from one to five years. And the higher rates it offers is due to the fact that your money stays locked in for a longer period. The national rate for a 60-month non-jumbo CD is 0.33%, as of January 2021.
Long-term CDs are better suited as provisions for significant expenses in the future like your children’s tuition fee. It can also be your nest eggs for retirement.
In choosing between the two, you must be clear with what you’re providing for because you can’t touch the money that you put in a CD until the term ends. If you choose to do so, you would have to pay a penalty fee, which could then eat up some of your returns.
A 1-year CD, as its name suggests, is a CD that locks in your funds for a full twelve months. If you’re contemplating whether you’d invest in this savings product, this section will help you decide by highlighting its advantages and disadvantages.
Switching to higher rates is not problematic. A 1-year CD is a common choice for investors because of the flexibility it offers. This is helpful if CD rates started to rise, allowing you to invest in a better-paying one just after a year.
Low rates. A clear disadvantage for keeping your money with a 1-year CD is it provides a relatively low yield. It differs from the 60-month CD's rate by almost twofold.
Enables you to seek other investment opportunities after a year. One year is not a long period to store away your money, so if you find a higher yield from a different investment vehicle, you'd be able to move your funds from your CD to that new investment after only twelve months.
Rate Changes. The rates your CD has is only good until the CD's term length. Suppose you managed to secure high rates before external factors reduce the national average, but your CD's maturity date is due next year. In that case, it will be hard for you to find another one that offers a comparable rate.
You can withdraw all your funds after one year with no penalties. Financial emergencies can happen, and regaining your funds' liquidity in just a year can be helpful to your situation.
If you’ve decided that a CD is a right investment for you, here are some steps you can follow to open your account:
It depends on the purpose. If you’re transferring it to another person, you must first check with your bank’s policies if this is something they allow. But if the name change is due to marriage, for instance, then the bank will mostly comply as long as you provide updated documentation.
In the US, a CD’s interest payments are taxed as interest income, and there are several variables, like the tax bracket you fall under, that you need to check to know the precise amount you have to pay.
Most CDs are fixed, which means that you get the exact amount of interest payments until the term ends. Therefore, you generally can’t add more funds to it unless it is stated otherwise
CDs may provide you with better returns than bonds over the long run due to their interest on interest payments. However, if interest rates are low, bonds may be the better option because yield rises if interest rates are low.
Some issuing banks or credit unions have a minimum deposit to open a CD, like $1,000 or $500. But some don’t require it all.