Originally published by David McMillin on Bankrate.com.
If you’re looking for a safe place to store your money while earning a return, you might be thinking about opening a certificate of deposit.
A CD is similar to a traditional savings account, but your bank will pay you a higher interest rate in exchange for locking your funds away for a set amount of time.
The catch for that extra earning potential? Most CDs will charge you a penalty if you need your money before the end of your term.
Right now, though, that extra earning potential isn’t all that much to celebrate. The best rates on 3-year CDs are under 1.25 percent, which means your money will be tied up for a long time with limited benefits.
“I tend to shy away from CDs in today’s environment since the interest rates on these are not materially higher than money market and other deposit accounts,” says Andrew Feldman, CFP, president of Illinois-based AJ Feldman Financial. “And most CDs lock up your funds and are not liquid.”
Depending on your financial goals and your risk tolerance, CDs might still make sense. However, there are other options to minimize your risk and maximize your earnings.
1. Dividend-paying stocks
Some companies pay out portions of their profits to shareholders on a regular basis. Major names like Starbucks and Walmart pay dividends that beat average CD rates. Some companies have a long history of raising dividends, too. For example, Verizon has increased its dividend for 14 years in a row.
Investing in dividend-paying stocks carries the potential to earn a yield higher than CDs, but there’s a real risk you could lose your principal, too. Buy a stock at $20 per share today, and it could be worth $15 per share six months from now.
Kimberly Foss, president of Empyrion Wealth Management in Roseville, California, says because stocks can come with such risk, you have to ask yourself how much risk you’re willing to take.
While that risk can be significant in the short term, it becomes lower in the long term. That’s why you should plan to hold on to any stocks for a period of at least three to eight years.
Many financial advisers recommend against picking individual stocks. Mari Adam, president of Florida-based Adam Financial Associates Inc., says if you take this option, it’s best to spread your risk among a couple of stocks and other investing vehicles.
“You don’t want to put all of your short- or mid-term cash in just one stock or one alternative,” Adam says.
After a 2020 filled with uncertainties amid the pandemic, investors should remember the need to stay the course. You’re investing for the future, not just following the constant swings of the market.
“You really have to keep focused on what your goal is and don’t get distracted by what the market’s doing today or what’s on your statement today because if you do that, you get off that path and you don’t want to do that,” Adam adds.
2. Paying down high-cost debt
Earning a return doesn’t necessarily involve “investing” in the traditional sense. It can also involve getting rid of high-cost debt that might be dragging you down.
If you’re carrying a balance on a credit card with an interest rate of 15 percent from month to month, you’re going to be paying more than the interest you could accrue on a CD or any other traditional saving product.
It’s much better to use your money to get that bill to zero than put it in a low-risk option that might pay 2 percent interest annually.
“Mortgages and a car note might be OK, but you should be paying down anything with a double-digit interest rate,” says Bill Hammer Jr., president of New York-based Hammer Wealth Group.
Paying down credit card debt also protects you against rising interest rates in the future. And once the debt is paid down, it will be easier to put away money on a regular basis and build up your savings.
“Paying down debt is one of the only ways you can get a guaranteed risk-free return,” Hammer says.
3. Peer-to-peer lending
While you want to pay down your debts, others like you might need to borrow some money. Peer-to-peer lending, often known as “P2P lending,” is a creative option if you’re willing to take a little risk for higher reward, Empyrion’s Foss says.
Consider Prosper, which lets you make loans to random strangers and earn a good annual return. Prosper’s data shows that individual investors earn average annual returns of 5.3 percent.
You can lend to borrowers in different risk categories based on their credit scores. Just as a bank can charge a higher interest rate for those with lower credit scores, you get a higher interest rate for agreeing to loan to individuals with less-than-perfect credit.
Foss says it’s a less risky option than the stock market. She recommends sticking with borrowers who have AAA ratings.
“I wouldn’t put all of your cash here, but it might work well as part of a portfolio with dividend-paying stocks and a short-term corporate bond fund,” Foss says.
4. Bond funds
Short-term bond funds are another alternative to investing in CDs. Funds have similar terms such as 1-year and 5-year maturity dates, and they hold bonds in everything from foreign countries to utilities to corporations.
The yields can be quite strong, too. For example, Vanguard’s Short-Term Bond Index Fund, which spreads money across corporate bonds and U.S. government bonds, has earned a 4.78 percent return over the past year.
Another option could be an international bond fund. Many of these funds hold bonds from AAA-rated, creditworthy nations such as France, United Kingdom, Germany and Japan.
There are also emerging market bond funds, although these carry bigger risks.
As you get started, read Bankrate’s guide on how to invest in bonds to educate yourself on the wide range of options.
CD vs. money market vs. Roth IRA
Trying to choose between a CD, a money market account and a Roth IRA? The right answer depends on how you’re planning to use the money you’re stowing away.
If you’re looking for a place to park your emergency funds, for example, you’re probably better off putting it in a money market account, Adam says. That way, you can withdraw it as soon as you need it without concerns of a penalty.
You’ll earn a little bit, too, but nothing to write home about. In the current climate, the best money market rates are sitting around 0.5 percent.
A CD might be a good place for short-term cash you’re planning to use within a year for an expense like buying a car or a house. But it’s not a good place for long-term retirement funds.
Those kinds of savings should go into a retirement account instead, like a Roth IRA that allows withdrawals in retirement to be made tax free since contributions are made with after-tax dollars. And if retirement is still far off in the distance for you, it’s essential to think about the best long-term investments for your strategy.
Are CDs worth it?
Right now, you’ll be hard-pressed to find an interest rate on a standard CD that will justify locking up your funds for an extended period of time. While traditional CDs may not be worth it in the current market, you may want to explore some alternative options for CDs.
For example, Ally Bank offers a CD that gives you the option to request a rate increase that adjusts to the bank’s updated rate (once for the two-year CD and twice for the four-year product).
A number of banks including Marcus by Goldman Sachs offer a CD that allows you to withdraw your funds without paying a penalty.
Be sure to compare Bankrate’s best investments to determine which vehicles are the right avenue for your growth needs.
Are CDs a smart retirement strategy?
“If you [are a] younger person, you’re investing for retirement or something that’s a long-term investment you want, you shouldn’t be in CDs because those are short-term investments in my opinion, with low returns,” Adam adds. “You can’t fund your retirement on a two point whatever return. You’ve got to get more growth.”
To find that growth, Elliot Pepper, CPA, CFP, MST, financial planner and director of tax at Maryland-based Northbrook Financial, recommends target-date funds.
“Many large institutions offer target-date funds, which are very popular in 401(k) or retirement accounts as they essentially offer a set glide path away from riskier investments and into more conservative fixed income investments based on the target date of the fund,” Pepper says.
Once that target date arrives and you actually do retire, CDs might be a good addition to your portfolio. However, it’s important to note that you might luck out and live even longer than you expect. In that case, you could need more than earnings from CDs.
Are CDs tax-free?
A CD will pay you some interest, but you’ll also have to pay taxes on that income. That may take a significant bite out of your earnings, especially if you aren’t saving that much money to begin with.
If you have IRA CDs, you won’t pay taxes on contributions or any interest until you withdraw the money in retirement. If you open Roth IRAs, your distributions in retirement would be free from taxation.
If you’re genuinely concerned about your tax situation, you may want to turn to an alternative — like a municipal bond — to avoid the taxation problem altogether.
Best returns for short-term and long-term funds
A CD is just one option if you’re looking for a place to stash your short-term funds. There is a variety of alternative options, especially if you’re looking for a higher rate of return and are willing to accept the tradeoff with a higher risk.
Besides municipal bonds and short-term bond funds, you could earn a higher yield by investing in a mutual fund. Depending on how you invest your money, you could end up with a yield in the double-digits.
For your long-term funding needs, you’ll need to look beyond CDs.
“CDs aren’t always the right choice, especially if you won’t need the funds for several or more years,” says David Sterman, CFP, president and CEO of New York-based Huguenot Financial Planning. “Funds that focus on longer-term bonds will always offer better yields than CDs.”
Amanda Dixon contributed to some of the original reporting of this updated article.
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