Maximizing your CD earnings will require more than just opening the most long term cd investing or obvious certificates. In fact, there are as many pitfalls as there are opportunities. So be careful to avoid these costly CD mistakes.
Here are 6 costly mistakes to avoid when investing in CDs. Not being ready for the Fed rate hikes. CD savers who don’t follow Federal Reserve headlines do so at their own peril, as they could easily lock in a CD yield right before the Fed announces a rate hike. The Fed’s rate-setting committee meets every six to seven weeks to decide whether it will modify the federal funds rate. That rate is the interest commercial banks pay to borrow money from each other through the Fed, and it’s the lever the Fed uses to manage short-term interest rates across the broad economy. For seven years, the Fed kept this rate near zero as a stimulus to help the economy recover after the 2008 financial crisis. During that time, savings, money market and CD yields languished at historic lows.
If the Fed continues to make increases over the next few years — even if very slowly — what might we expect national bank averages to do in relation to the federal funds rate? The only other time the Fed methodically raised rates from an exceptionally low level was in 2003. Back then, the federal funds rate had plateaued at 1. When the federal funds rate was 1. 2003, the average 1-year bank yield was 1. By the time the Fed increases reached 3.
2005, the 1-year CD average had climbed to almost 3. No one knows if commercial banks will respond similarly this time around. Certainly, looking at what happened to rates in 2003-2005 could suggest undue optimism because the last seven years of Fed history are completely unprecedented. But it’s reasonable to anticipate that higher CD yields would be triggered if the Fed continues to hike rates. Buying long-term CDs that are costly to exit. Because the Fed’s increases are likely to take place over the next several years, committing to today’s rates for a 4- or 5-year CD can hurt you twice.
First, you’ll underearn future yields by a significant margin in the later years because rates will have climbed in the earlier years. Second, locking in your funds for such a long period prevents you from moving into any better-paying CDs that arrive. In an era of rising rates, liquidity and flexibility offer you an edge, so always be sure to review the early-withdrawal penalty for any bank where you’re considering opening a CD. A typical penalty is six months’ interest, and on a 5-year CD, that can be a reasonable forfeiture in exchange for being able to move your money to a better-paying CD. But other banks charge 12 or more months’ interest. Some even assess penalties that can subtract from your principal. So when faced with the choice between two long-term CDs of similar merit, opt for the one with the most lenient early-withdrawal penalty.