What if you could earn interest on your money at a fixed rate if you promised not to touch it for a fixed period?
That’s the basic premise behind a certificate of deposit, often referred to as a CD. This common type of savings account can be a good option for those who want to earn a higher interest rate than what many traditional savings accounts offer. It can also be another way to grow your money without the risk (or reward) of investing in the stock market.
What is a CD?
A CD is a type of savings account that pays interest in exchange for setting aside money for a fixed period. The interest rate will not change throughout the term of the CD as the rates that banks offer on CDs fluctuate with changes in the Fed’s benchmark rate or the federal funds rate. This means that savers can score better returns on CDs in high-interest rate environments.
Once your CD matures, you’ll have access to the amount you deposited as well as the interest you’ve earned. One big difference between a CD and a traditional savings account is that you cannot touch the money in a CD during the term.
“You might put $10,000 into a two-year CD with a 2.5% APY. Then you will be guaranteed that 2.5% rate no matter what happens to interest rates and the broader economy, but you cannot access your money until the two-year period is up,” says Anessa Custovic, chief investment officer and investment adviser representative at Cardinal Retirement Planning.
How much can you earn with a CD?
For example, if you did invest $10,000 in a 2-year CD with a 2.50% APY you’d earn $250 in the first year and have a total of $10,506 at the end of two years (or once the CD matures).
If you tap your money early, however, you’ll get hit with an early withdrawal penalty and lose some or all of the interest you’ve earned. Plus, you could end up losing some of the principal.
For example, if you have a term under one year, the penalty could be up to three months of simple interest. Aside from that penalty, it’s important to consider the amount of interest you’re missing out on as well.
Make sure to review the fine print: Federal law sets a minimum penalty on early withdrawals, but it doesn’t limit the maximum dollar amount you’ll be charged.
What determines CD interest rates?
The CD’s interest rate depends on the bank and the term lengthyou sign up for, which can be a 6-month, 1-year, 3-year, 5-year term or longer. Typically, the longer the term, the higher the annual percentage yield (APY), or the interest you’ll earn in one year. If you’re looking for a financial vehicle that can earn more than a savings account, but is less risky than investing, opening a CD may be a good fit.
Most CDs offer an APY that remains the same throughout the term of the CD, but there are CDs that offer variable APYs.
These CDs are known as bump-up CDs. They enable customers to increase the interest rate on their CD at least once during the CD’s term, which allows them to benefit from rising rates.
How do CDs work?
To open a CD, either online or through a bank, you can create an account or log in to your account if you’re an existing customer. If you’re a new customer, you must provide some personal information including your Social Security number to open an account.
Then, you’ll need to select the CD’s term, which will impact the APY you receive, and finally, you’ll add the amount you want to deposit. Some financial institutions require a minimum opening deposit, while some may not have any minimums at all.
The terms available will depend on the bank you choose and can be anywhere from one month to 10 years.
What happens when a CD reaches maturity?
Once you deposit funds in a CD account, you keep them there until the term is complete. Once the term is up or the CD “matures,” you’ll usually be given a grace period during which you can access your principal (the amount you initially deposited) and the interest paid out on your deposit.
If you don’t take action, the CD may be automatically renewed for another term (of equal length), but the interest rate may not be the same as your initial term.
Are CDs safe?
CDs are considered safe investments because when you opt to open a CD at a bank or credit union that’s insured by the Federal Deposit Insurance Corporation (FDIC) or National Credit Union Association (NCUA), they’re considered deposit accounts which means they’re covered up to $250
“Just like deposits in your bank account, CDs are FDIC-insured up to $250,000, so on the spectrum of low- to high-risk investments, CDs are about as safe as you can get,” says Sturgeon. “However, in locking up your money, you’re subjecting yourself to other risks, including pressure from inflation and the opportunity risk of not being able to deploy those funds elsewhere.”
As opposed to investments in the stock market, you don’t run the risk of losing funds you deposit into a CD. The only time you may not see gains on your funds would be if you break the terms of the CD and incur penalties by making an early withdrawal.
Who are CDs for?
CDs may not be right for everyone. Since CDs are riskless investments, you’ll be trading returns for safety.
“A CD is a savings vehicle that’s typically sold by banks to consumers as a low-risk, low-return way to hold cash for a given period of time,” says Scott Sturgeon, CFP, founder and senior wealth adviser of Oread Wealth Partners. “Among a certain set of the population—typically older investors—CDs are pretty popular, but not necessarily as much with younger investors.”
If you have a shorter investment horizon or are closer to retirement, CDs can be a solid option as they’ll offer you a steady return before you’re say, ready to retire or purchase a home.
“Typically, I recommend retired clients hold around 12 months’ worth of expenses in cash and cash equivalents at any given time,” says Sturgeon. “That might mean three months’ worth of expenses is in their checking account, another three months is in a high-yield savings account, and the remaining six months is tied up in other low-risk investments like CDs, Treasuries, etc. In doing so you’re creating a ‘waterfall of liquidity’ to fund your lifestyle in retirement.”
CDs vs. savings accounts
While CDs are a type of savings account, they aren’t the same. If you want to access your money whenever you want, opt for a high-yield savings account or money market account (MMA) instead.
While these accounts typically provide lower yields than CDs, they’re more liquid, so you can tap your money as needed. A savings account can be used for quick and easy access to funds for emergencies, vacations, and home or car repairs.
(Note: some banks may limit the number of withdrawals you can make from a high-yield savings accounts or MMA).
“Whether it makes sense to use a CD or a savings account is largely dictated by liquidity needs and risk. Both are relatively low risk, but with a CD, you’re locking in an interest rate for a set length of time, but also locking up that money as well. With a savings account your interest rate might fluctuate up or down, but you can withdraw those funds at any time,” says Sturgeon.
However, for some, it could be a good idea to have both a savings account and a CD.
“Once your savings account is in a comfortable place then the excess is put in a CD,” says Custovic. “You could also use it when it’s earmarked for a specific purchase at a set future time. For example, maybe you know you will be looking at houses in one year. You can put your down payment into a CD to earn more interest on it during that time period.”
What to consider when shopping around for a CD
Here are the key elements to consider when comparing CDs:
- Any minimum balance requirements
- The various terms offered
- The interest rates offered: Online banks typically offer higher rates than brick-and-mortar ones
- Potential penalties for withdrawing funds early
- Any fees associated with the account (You might be able to avoid fees by using a bank, rather than a broker.)
Are CDs taxable?
Before you invest in a CD, you’ll want to consider the tax burden. The interest you earn on a CD is considered interest income which is typically subject to federal, state, and local taxes.
Interest income is taxed at the same rate as ordinary income and is taxed the year you receive it (i.e. when you can withdraw it without incurring a penalty). If you earn at least $10 worth of interest in a year, you’ll have to report it on Form 1099-INT.
Pros and cons of CDs
CDs can be attractive because of the certainty and predictability they offer. On the other hand, CDs tie up your funds for a set period and you can’t easily access them Evaluate the pros and cons before opening a CD account.
Pros
- Higher APY than other savings vehicles
- Fixed rates
- Flexible term options
Cons
- Returns not as high as investing in stocks or some other asset classes
- APY is locked in and doesn’t account for inflation
- CDs are illiquid, so you cannot easily access funds without penalties
What are CD ladders?
If you want more liquidity but still want to take advantage of the safety of a CD, you might consider building a CD ladder. With a CD ladder, you purchase multiple CDs of staggering maturities. Once each CD matures, you reinvest your money in new CDs.
For example, you could purchase three CDs: a 1-year, 2-year, and 3-year CD. After each CD’s term is up, you would reinvest those funds in a 3-year CD. This way you have access to your funds every year.
Will CD rates go up?
If you’ve been contemplating whether to invest in a CD, it’s time to take the plunge. Interest rates are at a more than 20-year high, and Fed Chair Jerome Powell has asserted there will be three cuts this year, but hasn’t indicated when.
What does this mean for CDs? Since CD rates move with changes in the federal funds rate, a decline in the federal funds rate means that CD APYs will decline. In other words, CD rates at their peak right now. In fact, the national deposit rate ona 12-month CD is 1.86%, up from 0.25% in June 2022.
The best CD rates of March 2024
If you’re willing to do some shopping around, you can find rates on CDs that exceed 5%.Here are a few institutions you might want to consider:
- BMO Alto: Up to 5.50%
- First Internet Bank: Up to 5.35%
- MYSB Direct: Up to 5.30%
- TAB Bank: Up to 5.27%
- Quontic Bank: Up to 5.05%
Best CDs by term length
The takeaway
Depending on where you open a CD, the rates may be abysmally low or higher than you might get with a traditional or high-yield savings account. In other words, it pays to shop around to check rates. But before moving forward with a CD, assess your needs and goals to better understand how the term will impact your finances.
“When it comes to the term of your investment in a CD, it’s important to ensure the amount you’re investing meets your liquidity needs,” says Sturgeon. “That’s because in the event you need to liquidate your CD early, you’re going to pay a decent amount in fees to the point where it would have probably been better to just keep your cash in your bank account to begin with.”
