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Monday, June 22, 2009

Investing in CDs: A Safe, Short Term Strategy

When it comes to money, it usually doesn't pay to bury your head in the sand. However, I must admit, that it has been months since I've opened an investment statement or logged on to see how our 401(k)s are doing.

Like many investors, our portfolios have been hit hard. In the span of 10 days last fall, they lost 30 percent of their value, and that wasn't even rock bottom. I never thought we would lose as much money as we have, let alone have it to lose.

I've been avoiding those monthly statements because I'm trying not to panic about the sorry state of the economy and the stock market. I'm trying to follow the advice of our financial planner and other wise counselors who advise that we should invest for the long term, not the short term.

However, there are times when a shorter-term investment makes better sense. As part of our overall investment strategy, we have money stashed in 401(k)s, IRAs, mutual funds, stocks and CDs.

We bought our first CD shortly after our son was born, in hopes of earning a better return on some of our liquid savings. We chose a CD because CD rates are generally better than a traditional savings account, CDs are FDIC insured, and because we planned to use some of that cash toward a downpayment on a new house in a few years.

When you purchase a CD, you invest a fixed sum of money for fixed period of time – six months, one year, five years, or more – and, in exchange, the issuing bank pays you interest, typically at regular intervals. When you cash in or redeem your CD, you receive the money you originally invested plus any accrued interest. If you redeem your CD before it matures, you may have to pay an “early withdrawal” penalty or forfeit a portion of the interest you earned.

Our CD is nearing maturity again, so I've been searching around to find the best rates at sites like Monitor Bank Rates, which is a clearinghouse for the best rates on CDs, credit cards, mortgages, car loans, savings accounts and other personal financial information. The site lists rates for Chase CDs, Wachovia CDs, eTrade CDs and other big banks and investment houses, as well as community banks when you put in your ZIP code.

One thing I've learned after our first stint of CD investing is that the tradeoff for lower risk is a lower returns. It's laughable how little we made on the money we invested in our initial six-month CD. We're talking around $50 on a $5,000 investment. We knew the rate going in, but my husband and I are both word people, not numbers people. We couldn't compute what 2 percent interest would work out to in six months!

That's why I'm really loving these nifty CD calculators. You just punch in your investment, choose your interest rate and your term and find out how much money you'll be sitting on at the end of that time. Before I started playing around with the calculators, I thought the key to CD investing was shopping around for the best rate. While that's important, it's also important to choose the right CD term for your financial needs. Longer term CDs may pay higher rates. But if your need the money this year, a longterm CD isn't a good idea.

After schooling myself some more on CDs, I'm considering CD laddering when ours matures. This strategy helps minimize risk and maximize returns. You can learn more about laddering here, here and here, but here's a quick primer:

If you have a chunk of cash that you've been holding onto, waiting for the economy to improve and the stock market to settle down, laddering CDs may be a good option. The beauty of a CD ladder is that you lower your risk and increase your return without losing access to at least some of your cash.

You start the ladder by buying several CDs at one time but with different maturity dates, for example, one year, two year, three year, four year, and five year CDs. Every year one of your CDs will mature and you can roll it over into a new CD with a longer term (if rates are high) and higher rate.

Such a strategy can really pay off, even on a relatively small investment. For example, according to the CD Ladder Calculator at Monitor Bank Rates, by laddering a $10,000 investment into 5 CDs, you could earn an additional $823. Not chump change. Have $20,000 to put into CDs? Laddering could earn you an extra $1,646.

I'd love to hear from anybody who has had experience with CD laddering to find out if it worked for you. I'll keep you posted, as well, about our experiences with CD investing and CD laddering.

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