If you’re seeking to earn higher interest rates than you would through a bank account and you don’t need to access to your cash for a while, you might want to consider a certificate of deposit, or CD.
But what is a CD, exactly? Read on.
What Is a CD?
A certificate of deposit (CD) is an alternative to a savings or money market account that allows you to save a set amount of funds with a fixed withdrawal date and a fixed interest rate.
Because you must leave the funds in the CD account untouched for the agreed upon amount of time, you can earn higher interest rates than you can with traditional savings or money market account.
CDs are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 in the same way that savings and money market accounts are, making CDs a low-risk investment option.
Bank with a credit union? Ask your branch about share certificates, which are the credit union equivalent of CDs. These are also insured for up to $250,000, but by the National Credit Union Administration (NCUA) instead of the FDIC.
The length of time it takes a CD to reach maturity can vary greatly — typically from six months to five years, though you can technically find CDs with terms as short as a few days or as long as a decade. In general, the longer the duration of your CD, the higher interest it will pay out.
However, if you must withdraw the money early, you will be subject to fees, which also vary. Often, it totals a good chunk of the interest you’ve earned, which defeats the purpose of the investment.
When It Makes Sense to Open a CD
There are several pros to opening a certificate of deposit with your bank:
- You’ll typically earn more interest than you would with a savings account. The national average for APY for savings accounts at brick-and-mortar banks is just 0.09%. For a 60-month CD, the national average is 1.03%, though the best APYs for CDs currently range from 2% to 3%. However, many online banks now offer competitive APYs on savings and even checking accounts that are competitive with CD rates, but with easier access to funds.
- CDs are a low-risk investment. While stocks and bonds usually earn you better returns, they’re also riskier. You assume less risk by putting some of your funds into a CD.
- There’s less temptation to spend. If you are saving for a clear goal — like a wedding in a year or a house down payment in five — a CD is a great way to protect that money while it grows thanks to interest. Because of the withdrawal fees, you will be less tempted to access that money for an impulse buy that ultimately puts a dent in your savings goals.
Opening a CD makes sense when you are free of credit card debt and already have an emergency fund built up in your savings. Because the interest rate of credit card debt is higher than what you’d earn through a CD, it makes sense to pay off that debt first before opening a CD.
Debt-free and ready for an emergency with a healthy savings account? A CD might be right then. But remember: Diversifying your money tends to yield the best results.
Because you’ll pay a fee if you withdraw money early from a CD, aim to save three to six months of expenses in a high-yield savings account before opening a CD.
The Disadvantages of CDs
CDs are not without their downsides. Disadvantages include:
- CDs require you to freeze your money for a set amount of time, often years. If an emergency comes up and you need that money, you will pay a penalty to access it.
- They earn low returns compared with stocks and bonds.
- The interest rate is fixed. That means if interest rates go up on CDs at your bank, you can’t take advantage of the new, higher rate, which is especially frustrating with longer-term CDs. A good solution for that is called the CD ladder; more on that below.
How to Optimize Your Investment With a CD Ladder
Because long-term CDs offer higher interest rates, five-year CDs are attractive to savers. However, forking over your cash for five years can be difficult, especially if the minimum deposit is large or you expect interest rates to go up.
Instead, you can split your deposit amount into fifths and open five CDs: a one-year, two-year, three-year, four-year and five-year CD.
When the one-year CD matures, you can pocket the interest and invest the initial amount in a five-year CD. A year later, the two-year CD will mature, and you can do the same. Eventually, you will have five five-year CDs with one maturing each year.
This makes funds more available to you on an annual basis but achieves the overall higher interest rate of a five-year CD versus a one-year CD.
Other Types of CDs
Generally, banks offer CDs at a fixed rate and for a fixed duration. However, you may encounter special types of CDs with unique terms:
- Jumbo CD: These carry a high minimum balance requirement (think $100,000 or more) but come with a much higher rate.
- Step-up CD: These CDs include predictable interest rate increases at specified intervals throughout the term of the CD.
- Bump-up CD: These CDs allow you to request a rate increase (though many are limited to a single rate increase for the duration of the CD). Having this flexibility often requires a higher minimum deposit and a lower interest rate.
- Liquid CD: These CDs give you access to your funds without penalty. For this flexibility, the terms may include a higher minimum deposit and lower interest rate.
Timothy Moore leads a team of editors and graphic designers at a market research company as his full-time gig. As a freelance writer, he writes about personal finance, careers, education, pet care, travel and the automotive industry. His work has been featured on Debt.com, The Ladders, Glassdoor and The News Wheel.
This was originally published on The Penny Hoarder, which helps millions of readers worldwide earn and save money by sharing unique job opportunities, personal stories, freebies and more. The Inc. 5000 ranked The Penny Hoarder as the fastest-growing private media company in the U.S. in 2017.
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