Deciding on whether a CD is worth adding to your financial portfolio can be a tough call. While you’ll earn a solid annual percentage yield, or APY, now, it may not be worth it if your earnings are eaten away by early withdrawal penalties should you need the funds before the CD term matures.
The answer still isn’t all that simple. You’ll need to consider such factors as your saving goals, how much you’re willing to set aside and even taxes. Here’s how to decide if a CD fits into your savings strategy and other options to consider.
Pros and cons of CDs
A certificate of deposit -- or CD -- is a low-risk savings vehicle that offers a guaranteed rate of return. These accounts come in a wide range of terms, as little as one month to five years. While a guaranteed return is always good news, there are upsides and downsides to consider before opening one:
Pros
Fixed interest rate: Regardless of what happens in the market, the interest rate you lock in for a traditional CD will remain the same for the entire term. Even if interest rates decline for other CDs, your rate won’t change until your CD matures.
Higher interest rates than other savings products: Most CD rates are higher than what you’ll find for traditional savings and money market accounts. However, this isn’t always the case. Right now, some big banks are offering very competitive CD rates -- between 4% and 5%, but some traditional branch banks are still offering 0.05% range for longer-term CDs.
Insurance coverage: The recent failures of Silicon Valley Bank and First Republic may have you worried about what happens if your bank collapses. However, CDs are covered for up to $250,000 at federally insured banks and credit unions via the Federal Deposit Insurance Corporation (for banks) and the National Credit Union Administration (for credit unions).
Cons
Limited access: Traditional CDs can limit your access to your money in exchange for earning interest. If you need the funds before the term ends, you’ll pay a withdrawal penalty that may be more than the interest you’ve earned.
Taxes: Interest you accrue on CDs will be subject to federal and state taxes, which can put a dent in your earnings.
Inflation: When prices go up, the value of your dollar goes down. If you’re investing in a CD, the interest rate may not be high enough to keep pace with inflation. That means even though you’re earning a return, it may not be as valuable today as it would be in a period of low inflation.
Minimum deposit requirements: Some banks have higher balance requirements to score the highest CD rates. Make sure you compare a range of options to find the best rate based on your deposit.
When to consider opening a CD
A CD can be a great addition to your saving and investing strategy, especially if you fit into one of these categories:
You have a low-risk tolerance: If you’re nearing retirement age, or you’ve already left the workforce, wild swings in the stock market can be especially challenging, and there’s a greater risk of losing your hard-earned savings. The guaranteed rate of return with a CD helps you avoid that risk. Plus, you can use your regular interest earnings to help cover some of your expenses.
You have a goal with a specific timeline: Perhaps you want to buy a house next year, and you’re working to save for the down payment and closing costs. If you know that you’re focused on buying a place in 12 months, you may want to think about a short-term CD -- six months or nine months, for example -- to help accelerate your savings before you apply for a mortgage pre-approval. If, for example, you deposit $10,000 in a nine-month CD with a 4.50% APY, you’ll earn more than $335.64 when your CD term ends.
You want another layer to prevent overspending: CDs can also be a great way to avoid the temptation to spend your cash. Early withdrawal penalties can feel like a wise parent telling you what not to do. If you want to put an extra lock on your money that stands in the way of frivolous spending, a CD can help you think twice before withdrawing your cash.
When to avoid opening a CD
CDs aren’t for everyone. If you’re worried that you’ll need the money prior to the end of your CD’s term, don’t open a CD. For example, if your company recently went through a round of layoffs, your job security may not feel all that solid. With that in mind, it’s important to keep your cash accessible.
More so, if you’re young, new to the workforce and focused on placing aggressive bets on the stock market in the hopes of a long-term payoff, CDs may not be the best fit. Instead, you should look into other places to park your money where you can withstand the volatility and risk if you have a longer time horizon.
Read more: Should You Break a CD Early for a Better Rate?
CD alternatives
- Traditional savings accounts: These accounts provide a modest interest rate -- often lower than CDs -- but in some cases, there are no withdrawal restrictions. You may also have access to a physical location as most traditional savings accounts are at branch banks.
- High-yield savings accounts: These accounts offer higher interest rates than regular savings accounts. You may be able to store money without fees or requirements, depending on the bank.
- Money market accounts: These accounts usually involve a higher minimum balance than a savings account and may require a higher minimum balance to earn interest. But you’ll have more checking account features such as an ATM card and check writing.
How to maintain flexibility while using CDs
Don’t let the withdrawal restrictions of traditional CDs scare you. You can deposit some of your money into a CD while setting aside other funds to have easy access to when you’re in a financial pinch. Here are some other savings options to maintain flexibility while scoring the higher earning potentials of CDs:
Look for a no-penalty CD: No-penalty CDs mean you won’t pay a penalty if you wind up needing some -- or all -- of your money. While you’ll earn a lower rate than a traditional CD, you could set aside some of your money for a no-penalty CD to ease your money worries.
Keep some of your cash in a high-yield savings account: The best high-yield savings accounts are paying upwards of 4% right now. You’ll get the best of both worlds with these: a high APY that’s on par with CD rates and easy access to your money for regular contributions and withdrawals.
Build a CD ladder: CD ladders are a great strategy for diversifying your money with minimal risk. For example, let’s say you have $12,000 to put in a CD. Rather than locking all of it in a three-year CD, you might deposit $3,000 in a six-month CD, $3,000 in a one-year CD, $3,000 in a two-year CD and your remaining $3,000 in a three-year CD. This way, you’ll have money coming due every year, and you can spread out your funds across different rates.
Reevaluate your strategy during your grace period: Most CDs automatically renew shortly after the term ends, but you’ll have a grace period -- typically 10 days -- to think about whether you actually want to reinvest the money, withdraw it or pick a different place to keep it. Make sure you mark your calendar with your maturity date and watch out for alerts from your bank to determine the best route when your CD term is up.
Is a CD better than a high-yield savings account?
CDs and high-yield savings accounts both offer some of the best interest rates you can find today without taking on any risk. However, neither is necessarily better than the other; choosing one ultimately comes down to your timeline.
High-yield savings accounts are a great place to keep your emergency fund. This way, the money you’ve set aside for a worst-case scenario can continue to grow and you’ll have access to it if you need it on a whim. What’s more, you don’t have to choose just one account. Once you surpass your threshold for a proper emergency fund or another goal you may have, you might want to put some of that money in a CD to take advantage of a rate that beats the rate of your savings account.
The bottom line
CDs are a safe investment that can net you a higher return than most savings and money market accounts. Since rates have increased over the past year, they’re more appealing to some savers. However, traditional CDs come with a major string attached: You’ll pay an early withdrawal penalty if you need the money before your CD term ends. Before starting the process of opening a CD, make sure you’re comfortable with socking away your money for the duration of the CD’s term, but with the comfort of knowing you’ll accrue interest.
FAQs
The biggest drawback of opening a CD is losing your liquidity or flexibility to deposit and withdraw funds. Traditional CDs come with early withdrawal penalties, which will wipe away most -- if not, all -- of your interest if you take out the money before maturity.
Yes. While you can lose a lot of money in the stock market, one of the big selling points of CDs is that your principal is protected by FDIC insurance for up to $250,000, per person, per account at federally insured banks (and at federally insured credit unions through the NCUA). So, even if the stock market plunges, and the bank where you have opened a CD collapses, you’ll still get your money back.
To make sure that you don’t lose the money you’ve deposited into a CD, follow these two simple rules. First, make sure that your entire deposit is covered by FDIC or NCUA insurance. Second, don’t access the funds prior to the maturity date to avoid paying any early withdrawal penalties.
CD rates may rise a bit more in 2023, but don’t hold out for any kind of major increase. There’s a chance that the Federal Reserve won’t raise rates again next month, so CD rates seem poised to level off. If you’re planning to open a CD, now may be the best time before rates drop.
Correction: An earlier version of this article was assisted by an AI engine and it mischaracterized some aspects of CDs and savings accounts. Those points were all corrected. This version has been substantially updated by a staff writer.
As a seasoned financial expert with a deep understanding of investment strategies, particularly in fixed-income instruments, let's delve into the concepts presented in the article about Certificates of Deposit (CDs) and their role in a diversified financial portfolio.
Fixed Interest Rate and APY: The article emphasizes that one of the key advantages of a CD is the fixed interest rate it offers. This means that regardless of market fluctuations, the interest rate remains constant throughout the entire term of the CD. Additionally, the concept of Annual Percentage Yield (APY) is introduced, representing the effective annual rate of return, including compounding.
Interest Rates in the Market: It's mentioned that CD rates are generally higher than those offered by traditional savings and money market accounts. The article touches on the current market scenario, where some banks offer competitive rates ranging between 4% and 5%, contrasting with traditional branch banks that may offer significantly lower rates.
Insurance Coverage: The article discusses the security aspect of CDs, highlighting that they are covered up to $250,000 at federally insured banks and credit unions through the Federal Deposit Insurance Corporation (FDIC) and the National Credit Union Administration (NCUA), respectively.
Drawbacks of CDs: Several drawbacks associated with CDs are outlined, such as limited access to funds without incurring withdrawal penalties, taxation on accrued interest, potential inflation risks, and minimum deposit requirements for higher interest rates.
When to Consider Opening a CD: The article provides insights into situations where incorporating a CD into one's financial strategy can be beneficial. For instance, individuals with low-risk tolerance, specific short-term financial goals (e.g., down payment for a house), and those seeking a deterrent against frivolous spending may find CDs suitable.
When to Avoid Opening a CD: Conversely, the article advises against opening a CD if there's uncertainty about needing funds before the CD matures, or for young investors with a longer time horizon who are more inclined towards riskier investment options like stocks.
CD Alternatives: Alternative savings options are explored, including traditional savings accounts, high-yield savings accounts, and money market accounts, each with its own set of features and benefits.
Maintaining Flexibility with CDs: The article suggests strategies to maintain flexibility while benefiting from higher CD rates. This includes considering no-penalty CDs, keeping some funds in high-yield savings accounts, building a CD ladder, and reevaluating investment strategies during the grace period.
Comparison with High-Yield Savings Accounts: The article addresses the question of whether a CD is better than a high-yield savings account, highlighting that the choice depends on individual timelines and goals.
FAQs: Frequently asked questions cover concerns about liquidity, FDIC insurance protection, rules to safeguard deposited funds, and predictions about CD rates in the coming year.
Correction Note: The article concludes with a correction note acknowledging that an earlier version was assisted by an AI engine and had mischaracterized some aspects of CDs and savings accounts. This emphasizes the importance of reliable information and the need for human oversight in financial content.
In summary, the article provides a comprehensive guide for individuals contemplating the inclusion of CDs in their financial portfolios, addressing various considerations, advantages, and potential pitfalls associated with this investment vehicle.
