A solid cash management strategy is central to the success of any financial plan. Through effective cash management, you can preserve liquidity and collect interest to make timely bill payments, purchase big-ticket items, and spend cash to purchase investments that generate additional wealth. You may consider taking out a certificate of deposit (CD), as part of your cash management plan. To best coordinate strategy, you must become familiar with how CD interest rates are calculated.
CD Interest Rates: Identification
A certificate of deposit is actually a loan that you make out to the bank for a set period of time. In exchange for your loan, you collect interest until your principal is repaid at the maturity date. CDs are FDIC insured deposits, where you are protected with $250,000 worth of coverage at each bank that you patronize.
On a CD, the bank makes money when it invests your principal at a higher rate of return than your associated interest payments. The bank will charge fees to discourage you from taking an early withdrawal, because it is relying upon your principal as a steady source of capital to make investments.
CD Interest Rates: CD Maturity Dates
In general, you will collect higher interest payments with longer maturity dates. Banks offer higher interest rates for the privilege of securing capital for extended periods of time. In rare cases, CD interest rates will be higher for shorter time frames. These situations are referred to as an inverted yield curve. With an inverted yield curve, the market typically expects recession and lower interest rates in the future.
CD Interest Rates: The Federal Reserve Board
The Federal Reserve Board manages the interest rate environment through its federal funds rate. Banks borrow money from each other overnight at the federal funds rate to meet their Federal Reserve requirements. For CDs, banks pay a premium above the federal funds rate to access capital for longer periods of time. In recession, the Fed will lower interest rates to encourage institutions and private individuals to borrow, invest, and spend money. When the economy recovers, CDs will pay out more money as the Fed hikes rates to protect the economy against inflation. You can read the "Wall Street Journal" to monitor the federal funds rate and its effect on CD interest rates.
CD Interest Rates: Financial Risks
CDs are susceptible to inflation and interest rate risks. Inflation refers to a rising price level for goods and services, which erodes the future purchasing power of cash. The Bureau of Labor Statistics reports an average domestic inflation rate of 3 percent each year – through its Consumer Price Index. Meanwhile, interest rate risks refer to a scenario when rates move higher as you are locked into a long-term certificate.
CD Interest Rates: Strategy
You will incorporate CD laddering within your portfolio to preserve liquidity, manage risks, and provide for growth. Through laddering, you will divide cash between different CDs at various maturity dates. For example, you could put $1,000 each into a one-month, six-month, and one-year CD. With the one-month CD, you can take advantage of higher rates by rolling the money over into a new certificate each month. With the one-year CD, you can lock in relatively high rates, if interest rates were to actually fall.