Investors, Don't Write Off CDs Just Yet

In this environment of low interest rates, you may have written CDs off completely. After all, six-month CDs are only averaging 0.88% right now, and their one-year counterparts aren't much better at 1.38%.

But they can still be a useful part of your portfolio if you invest in them wisely. "We're not in CDs to earn a return -- not in this environment. We're in them because we don't want any capital fluctuations. We're really buying insurance," says Rick Kahler, a fee-only financial advisor and president of Kahler Financial Group.

So if you're already retired, you might invest a couple of years worth of living expenses in a short-term CD. No, you won't earn much, but if you hit a snag with the rest of your retirement income -- say, your investments are way down, and you don't want to sell low -- you can rely on the money you've stashed away in the CD to get you through. If you're still working and saving for a finite goal at a set point in the future, like a vacation, a CD is a good place to put your cash until you get there.

There are, however, a few things you need to know:

Go short term. There's really no where for interest rates to go but up, so some point in the future, we're going to see them rise. That increase is bad if you're carrying variable-rate debt, but it's good for your savings -- unless you're already locked in to a lower rate. So right now, you want to avoid doing that, and that means staying away from long-term CDs.

How long is too long? "I'm telling people not to lock into long-term CDs, but that doesn't mean we won't sit in this low interest rate environment for a longer period of time than most people might expect. Deflationary forces are still pretty prevalent in this economy. I wouldn't lock into a five-year CD, but I may lock into a one-year," says Kahler.

Note: There are CDs out there that come with extra bells and whistles -- one that's gotten a good deal of press lately is Ally's Raise Your Rate CD, a two-year CD that allows you to raise your rate once during the term. It's a bit of a gamble, because you could jump on the deal early, only to have interest rates shoot up even further. If that happens, you're still stuck in a long-term CD. Whether you want to take the risk is up to you, but keep in mind that you could do the same thing with a series of short-term CDs.

Look at your asset allocation. Cash is an important and legitimate asset class, and a CD will help you fulfill that portion of your portfolio. Particularly if you're a conservative investor, or your time horizon is getting short and you're nearly ready to start pulling money out, you may want to consider making CDs a part of your portfolio. The key words, though, are "a part." Too much cash, and you won't get the growth you're looking for, so stick to around 5% or 10% at the most.

Compare interest rates. You're not going to see a ton of fluctuation, but there is some, and it's worth doing a little research. I ran a national search on Bankrate.com -- my favorite place to compare interest rates on savings products -- and found rates as high as 1.55% on a one-year CD. When I looked only in my local area, rates were closer to 0.8%, and some were as low as 0.1%. As is the case with plain vanilla savings accounts, you'll likely find the best rates from online banks if you're willing to complete your transactions over the Internet.

Consider laddering. This is a savings strategy that involves investing in a few different CDs with varying maturity dates. The longer you lock up your cash, the higher your interest rate tends to be, so you can earn more of a return this way. For instance, if you have college tuition bills, you might ladder your savings in CDs so that one matures when the first semester's bill is due, one matures when the second semester's bill is due, and so on.

"You would ladder to meet your cash-flow needs. So say you have a payment you make quarterly, and you want to make sure the money's there. You could ladder CDs quarterly so you always have the cash available. But again, I wouldn't go too far out -- I might not ladder much past a year or a year and a half," explains Kahler.

Understand the rules. For the most part, if you pull your money out of a CD before it matures, you'll pay a penalty -- generally a portion of the interest earned. You don't lose any of your initial investment, and the penalty varies by bank, but you may forfeit three months' worth of interest for a six-month CD, or six months' worth for a longer CD. Keep this in mind when making your investment.