Flight to Safety: Why CDs are Worth a Second Look -- and How to Pick One


Diane Feen has been too scared to buy stocks or bonds since she lost some $70,000 when tech stocks went bust in 2001.

"I keep my money in safe CDs and money markets. I'm paranoid. I can't take risk. I'm not a doctor or lawyer making $200,000-$300,000 a year," says Feen, a writer in Boca Raton.

A decade later, she has plenty of company. Investors spooked by the stock market are thinking of one thing right now -- safety. In the flight from the fracas, for some, certificates of deposit never looked better.

While money in a CD is covered by FDIC insurance, up to the legal limit of $250,000, you still need a savvy investing strategy.

Here's how to get the most from your CD.

Assess Your Need

Think about why you need this money, and then match your liquidity needs with your personal financial circumstances, says Rich Arzaga, founder of Cornerstone Wealth Management. For example, if your main risk is unemployment, match the amount of reserves you have in CDs and other liquid, guaranteed accounts with how long you think it will take you to find work.

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For some people, this is three months. For others, it might be nine months. If you're going to need the money to pay school fees in a year's time, don't commit to a 5-year CD, warns Jonathan Hill, investment strategist at Gibraltar Private Bank & Trust.

Set Your Time Horizon

Determine how long you can set your principal aside. Just as some make the mistake of committing to a longer CD when they need the money sooner, others choose a shorter CD when they don't need the money until much later.

With longer-term CDs, you will get a higher interest rate and most banks will allow you to withdraw your interest on a regular basis -- many even monthly. So if you only need the interest, there's no need to have the full CD mature every year. Going longer-term gets you a better rate, while still earning you some income, says Jim Black, president of Absolute Return Solutions.

Build a Ladder

Another strategy that can prove useful in this low-rate environment in to "ladder" your CDs. Laddering simply means setting up multiple CDs with different maturities.

This strategy has two advantages. It allows you to take advantage of the higher rates of longer maturities while retaining the flexibility of having some of your money mature faster. If we are seeing the lowest rates of our lifetime, as some have speculated, laddering will enable you to reinvest money from the short-term accounts at the expected higher rates, Black says.

For more on laddering, check out bankrate.com.

Shop Around

Surf the Net for the best rates. Black likes Internet-only banks because they sometimes offer better rates. Sometimes national bank chains also pay better rates in different states, Black points out, so it can pay to search in other locations. Don't forget to include credit unions in your search.

You can buy CDs through banks or brokers. If you buy from a bank and you end up wanting to get out of the CD early, the bank will usually allow you to do this for a penalty, which is typically some part of the interest, says Kurt Winiecki, president of Winiecki Wealth Management.

If you buy through a broker, you can sell your CD at any time -- for whatever the market will pay -- without a penalty. This can result in a gain or a loss. If the issuing bank has problems, for example, the price may be too low to sell.

Read the Fine Print

Some CDs are callable, meaning that banks can end them early, and some come with variable or conditional rates, Hill says.

Ask about automatic renewals, suggests Grant Rawdin, president of Wescott Financial Advisory Group. You want to know what will happen at the end of the CD's term. Does it renew automatically if you do not give the bank notice 30 days before maturity? Also find out at what rate the CD matures.

Be aware that CDs aren't liquid during their term. You cannot cash them in without penalty, so choose a term for which you can be highly confident that you won't need the money, Rawdin says. CDs are more like short-term bonds than cash, so it makes sense to use CDs for the portion of your asset allocation that's reserved for bonds. For example, a portfolio with 10% cash, 40% bonds and 50% stocks might include CDs in the 40% bond portion.

Understand the penalties for early withdrawal. But don't hold yourself prisoner if you need to pull the money out of your CD before it matures, either. "Some people view the maturity date as sacred and are afraid to trigger the loss of interest," Arzaga says. "If there is a personal financial need greater than the value of the interest rate, then make the move."

Raise Your Growth Potential

Realize, too, that CD rates don't have the growth potential of stocks. "Know that you aren't keeping up with inflation and that's okay," says Holly Wolf, chief marketing officer for Conestoga Bank. That's why it's best to keep only a portion of your portfolio in such investments.

Some CDs, called step-up CDs, increase at a specified interval to help keep up with anticipated inflation. CDs that start at 0.25% yield and step up to 0.5% after a certain period of time are better than many other CD options, according to Dan Dingus, chief portfolio strategist for Fragasso Financial Advisors.

Also look for CDs that offer flexibility. Ally Bank, for example, has a Raise Your Rate CD that allows customers to raise their rates once (for a two-year CD) or twice (for a four-year CD), if Ally Bank's rates go up any time during their CD's term, Ally Bank spokeswoman Beth Coggins explains.

Don't Get Duped

Make sure that the CD is insured by the Federal Deposit Insurance Corp. Many temping offers that call themselves "high-yield certificates" are actually subordinated debts. They are often pools of investments in subprime credit-card debts, car loans and other things. These investments can pay 2% to 5% more than CDs, but they aren't FDIC insured and it's not unusual for these investments to fail, Rawdin says.

Some subordinated debts also can turn out to be Ponzi schemes. If you see a business promoting "bank deposit certificates" paying 5% interest, be wary: The best CDs today top out at 3%. Know your institution and look for the FDIC assurance, Rawdin warns.

You also need to understand the difference in rates between banks. A higher rate can be a warning of higher risk. "Avoid the teaser that may push you past your risk tolerance," says Renee Hanson, an Ameriprise Financial private wealth advisor.

Consider Other Options

Not everyone is singing CDs' praises. "They are insured and safe -- that's the best I can say about CDs," says Mallie Daniel, president of Wealth Creation Advisors. He's more of a fan of fixed indexed annuities.

"There's no downside risk to your principal, and you lock in your earnings annually," he says. "These accounts are tied to the [Standard & Poor's] and other indexes, but not invested directly in the market. When the market is up, the investor participates in a portion of the market returns and the earnings on those accounts are also tax deferred."

Feen admits that the rates on her CDs are paltry. She's getting 5% on an older one, but much less than 1% on her others. But she can at least sleep at night. And, as Wolf says: "Saving something, even at low rates, is better than not saving at all."