In today’s financial landscape, the average annual percentage yield on savings accounts barely reaches 0.35%.
While you might find a high-yield savings account with returns surpassing that figure, it’s important to remember that savings account yields can fluctuate unpredictably.
Enter Certificates of Deposit, or CDs, a low-risk savings option that allows you to earn compound interest while locking in a higher yield for a set period.
With a CD, you deposit your funds into an account and commit to leaving them untouched for a fixed term, during which the bank rewards you with a superior interest rate.
However, this benefit comes with a trade-off: you sacrifice some liquidity for the promise of a higher annual percentage yield (APY).
To make an informed decision about CDs, it’s crucial to understand how they work, as each type of CD offers its own advantages and disadvantages.
What you'll learn:
☞ What’s a CD (Certificate of Deposit)?
Opening a traditional CD involves depositing a lump sum with a bank or credit union (credit unions refer to them as share certificates). Your deposited funds then accrue interest at a predetermined rate over a set period.
Depending on your CD’s terms, your earned interest may either remain in the CD or be paid out to you at regular intervals, such as monthly or annually.
Unlike regular savings accounts, however, you typically agree not to make any withdrawals from your CD until it matures. Upon maturity, you can either withdraw the funds or roll them into a new CD.
As of May 15, 2023, the average savings account offered a meager APY of around 0.4%, according to the Federal Deposit Insurance Corporation (FDIC).
In stark contrast, 1-year CD rates averaged approximately 1.6%, and some of the best CD rates exceeded three times the national average. Hence, it’s essential to explore various CD options to maximize your savings’ earning potential.
It’s crucial to note that attempting to withdraw your money before a CD matures may result in an early withdrawal penalty.
These penalties can eat into or even negate the interest you’ve earned, underscoring the importance of careful planning and only investing funds into CDs that you can comfortably leave untouched for a predefined duration.
☞ How does a CD work?
Certificates of Deposit (CDs) are specialized deposit accounts offered by most banks and credit unions. They present a secure means of depositing funds while earning interest over time.
The key feature of a CD is its guarantee of returns, as long as you maintain your money in the account for a specified duration, during which the interest rate remains fixed.
The primary allure of CDs lies in their ability to provide a higher annual percentage yield (APY) compared to traditional savings accounts.
This elevated interest rate is a reward for committing to leaving your funds untouched for a specific period, which can range from as short as six months to as long as 60 months.
While your funds remain within the CD, the bank or credit union will credit you with interest, and this interest compounds—meaning you earn interest on both your initial deposit and the interest it accrues.
Upon the CD’s maturity, you receive your initial deposited amount along with the accumulated interest.
However, it’s essential to be aware of the limitations of CDs. They offer less liquidity than regular savings accounts.
Attempting to withdraw funds from a CD before its predetermined maturity date typically results in an early withdrawal penalty, potentially causing you to forfeit some of the earned interest.
☞ Pros & Cons of CDs
|👍 Pros 👍||👎 Cons 👎|
|– CDs provide guaranteed returns, offering a low-risk way to grow savings.||– Early withdrawal from a CD usually incurs a penalty.|
|– CDs generally offer higher returns compared to many other deposit accounts.||– CD interest rates, particularly on long-term CDs, may struggle to keep up with inflation.|
|– When you open CDs with federally insured institutions, deposits are insured up to $250,000 per financial institution.||– CDs typically yield lower historical returns compared to higher-risk investments like mutual funds and stocks.|
☞ What are the types of CDs?
Certificates of Deposit (CDs) come in various forms to cater to different needs and preferences. Here are some common types of CDs:
- Brokered CDs: These CDs are obtained through brokerage firms rather than banks or credit unions. They may offer higher Annual Percentage Yields (APYs), but it’s essential to verify the broker’s credentials on the US Securities and Exchange Commission (SEC) database.
- Step-up CDs: Step-up CDs feature increasing interest rates during the CD’s term. For example, the interest rate may rise annually, with predetermined rates for each year.
- No-penalty CDs: These CDs allow early withdrawals without penalties, but they often yield lower APYs compared to other CDs.
- Callable CDs: While callable CDs offer higher APYs, they can be terminated by the issuer before maturity if interest rates decrease, typically as early as six months after purchase.
- Variable-rate CDs: These CDs have interest rates that fluctuate with the market rather than remaining fixed until maturity. If interest rates rise, you can earn more, but they carry the risk of a lower APY if rates decline.
- Zero Coupon CDs: With zero coupon CDs, you purchase the CD at a discount, and it doesn’t pay interest during the term. Instead, you receive the full face value at maturity, resulting in an effective APY.
- Bull CDs: Bull CDs are linked to a specific market index, offering predetermined interest as the index rises, often with a guaranteed minimum rate of return.
- Bear CDs: Like bull CDs, bear CDs are linked to a market index, but they offer returns based on market declines. If the index decreases, the CD’s interest rate climbs.
- Jumbo CDs: Designed for those with substantial savings, jumbo CDs require a higher minimum investment, offering a more attractive APY in return.
- Bump-up CDs: Bump-up CDs allow you to request an increase in your APY if interest rates rise at your financial institution before maturity. Typically, you can request one rate increase per term.
- Uninsured CDs: These CDs are not protected by the FDIC or NCUA. While they may offer higher APYs, they involve more risk compared to traditional CDs.
Each type of CD comes with its unique features, advantages, and potential drawbacks, so it’s essential to choose the one that aligns with your financial goals and risk tolerance.
☞ 3 common CD saving strategies
When it comes to achieving your financial goals using Certificates of Deposit (CDs), there are several strategic approaches to consider.
CDs offer higher interest rates than regular savings accounts, but they require you to lock in your money for a specified period.
Here are three common CD saving strategies:
1. CD Ladder:
- How it works: Create a CD ladder by opening multiple CDs with different maturity dates. These dates are staggered, allowing you to access a portion of your savings at regular intervals.
- Example: Open 6-month, 12-month, and 18-month CDs, evenly distributing your savings among them. As each CD matures, you can access the funds or roll them into a new CD with a longer term.
- Benefits: Maintain periodic access to your savings while earning higher interest rates.
2. CD Barbell:
- How it works: With a CD barbell strategy, divide your savings between short-term and long-term CDs, avoiding medium-term options. The goal is to have access to some funds while maximizing interest rates.
- Considerations: Long-term CDs may not always offer the highest APYs, and locking in rates in a rising rate environment may limit future earning potential.
- Benefits: Combine liquidity with the potential for higher interest rates.
3. CD Bullet:
- How it works: The CD bullet approach is ideal for saving towards significant goals. Open multiple CDs with similar maturity dates, ensuring that the funds become available around the same time.
- Example: Saving for a home down payment in five years, start with a five-year CD. Each year, open a new CD with a shorter term (e.g., four-year, three-year) and deposit additional funds.
- Benefits: Funds from multiple CDs align with your goal’s timeline, allowing you to apply both the principal and interest earned.
Each strategy has its advantages, and the choice depends on your financial objectives, risk tolerance, and the flexibility you need to access your savings.
☞ 5 ways to compare CDs
When comparing Certificates of Deposit (CDs), it’s essential to carefully evaluate various factors to make an informed decision. Here are key elements to consider:
- CD rates can differ significantly among banks and credit unions. Rates are influenced by the institution’s financial situation and its need to attract deposits for lending purposes.
- Online banks often offer higher rates than traditional brick-and-mortar banks. Rates can range from 1% APY to several times that amount.
- Determine whether the CD offers a fixed or variable Annual Percentage Yield (APY). Fixed rates remain constant throughout the CD term, while variable rates can change over time.
- Variable-rate CDs may start with a higher initial rate but carry the risk of decreasing in the future.
- CD terms vary widely, ranging from as short as one month to as long as 25 years. The term you choose affects your APY and liquidity.
- Longer terms often yield higher APYs but limit access to your funds until maturity.
- Consider the penalties associated with early withdrawals. Traditional CDs typically impose penalties, resulting in the forfeiture of accrued interest.
- Penalties can vary depending on the CD’s term length and the timing of the withdrawal, ranging from three to 24 months of simple interest or more.
- Different banks and credit unions set varying minimum deposit requirements for their CDs, typically ranging from $500 to $5,000.
- Ensure that the minimum deposit aligns with your available funds.
When comparing CDs, carefully assess these factors based on your financial goals, risk tolerance, and liquidity needs. Shopping around and conducting thorough research can help you secure the best CD for your specific requirements.
☞ Are there any alternatives to CDs?
Consider these alternative financial products that can potentially offer higher returns and more flexibility:
High-Yield Savings Accounts (HYSAs):
- HYSAs often provide a higher Annual Percentage Yield (APY) compared to traditional savings accounts.
- Unlike CDs, they allow more flexibility in accessing your funds, typically without penalties.
Money Market Accounts:
- Money market accounts combine aspects of both savings and checking accounts.
- They offer competitive interest rates while permitting convenient access to your funds, making them a more flexible option.
Series I Bonds:
- Issued by the US Department of the Treasury, Series I Bonds offer a safe investment alternative.
- These bonds provide a fixed interest rate along with an inflation-adjusted rate, offering some protection against rising inflation.
- Series I Bonds issued during specific periods may offer attractive rates, such as the 6.89% rate for bonds issued between November 1, 2022, and April 30, 2023.
- If you seek higher returns and are willing to accept some level of risk, investing in index funds could be a viable alternative.
- Historically, index funds have delivered superior returns compared to CDs. For instance, the S&P 500, tracking major US companies, has shown an annualized 10-year return of 9.64%.
- Keep in mind that index fund prices can fluctuate, so they may not be as stable as CDs.
When deciding on the right financial product for your savings, consider your financial objectives, risk tolerance, and liquidity needs.
Exploring these alternatives allows you to tailor your investment strategy to better suit your individual circumstances.
☞ CDs FAQ
|What happens when a certificate of deposit matures?||When your CD reaches its maturity date, you can choose to either withdraw your funds or renew the CD. |
Renewal involves depositing the money into a new CD at the same bank with different terms and rates.
Depending on your bank or credit union, you might have a grace period to make this decision.
|Is my money protected in a CD?||Yes, your CD funds are typically federally insured, usually through the FDIC or the NCUA. |
Both agencies provide coverage up to $250,000, safeguarding your investment.
|Is it better to put money into a CD or savings account?||The choice between a CD and a savings account depends on your financial goals. |
Savings accounts are suitable for short-term needs and emergencies. CDs offer higher interest rates but are less liquid, making them ideal for long-term goals or significant purchases.
Be cautious with CDs if you may need the funds for routine or emergency expenses.
|Is it better to invest in CDs or stocks?||The decision to invest in CDs or stocks hinges on your age, objectives, and risk tolerance. |
For long-term goals, especially if you’re young, stocks offer growth potential. CDs are safer and preferable if you’re older or have shorter-term goals.
Consult a financial advisor for personalized guidance.
|Can you add money to a CD?||Generally, you cannot add funds to an existing CD. |
However, you can use additional funds to open another CD, either with the same bank or by exploring other financial institutions to find competitive rates.