A big part of the decision to save more money is deciding where to keep the cash you’re putting away.
While a savings or money market account may seem like an obvious storage place for your dollars, another vehicle may be more appropriate, depending on your goals and time horizon.
A certificate of deposit (CD) could be a good place for your funds if you’re looking to earn additional interest and it’ll be a while before you need to access the money you’re setting aside.
What is a CD and how does it work?
A CD is an account offered by banks and credit unions. If you visit a brokerage firm, you’ll find that some offer CDs, too, from different financial institutions.
Funds in a traditional CD are tied up for a set period of time in exchange for paying a certain amount of interest. Usually, there’s a guaranteed rate of return. Once a one-time deposit is made, the money locked up in a CD typically can’t be touched without triggering a penalty and forfeiting some amount of interest earned — and in some cases a portion of the money you used to fund the account. But terms and conditions vary depending on the kind of CD you invest in.
With liquid or no-penalty CDs, for example, you’re not penalized for withdrawing your money (as long as the account is at least seven days old). And add-on CDs seem like savings accounts, allowing account holders to make multiple deposits over time.
When your CD matures, you’ll typically have a couple of options: withdrawing the money or letting it automatically be rolled into a new account.
How much interest can you earn with a CD?
CDs often come with a fixed interest rate that applies until the term ends. But some banks offer step-up or bump-up CDs, which allow the yields tied to accounts to increase, according to set intervals or one time during the term.
The amount of interest you can earn from a CD varies depending on multiple factors. Online banks tend to pay higher rates than brick-and-mortar banks. How much interest you’ll earn also depends on how thirsty a certain bank or credit union is for deposits. Competition, changes in Treasury yields and economic conditions, like the rate of inflation, also come into play.
Long-term CDs typically pay higher yields than short-term CDs. To earn a higher yield, you’ll usually have to open a four-year CD or five-year CD. But depending on the interest rate environment we’re in, opting for a long-term CD may not make sense.
If interest rates are rising, for example, it’s best to go with a short-term CD. That way, you’re not missing out on better offers that will likely come as short-term interest rates increase. If the opposite is true and interest rates are expected to go down, locking in a higher rate through a long-term CD may be worth considering, depending on how soon you’ll need the money you’re putting away. Of course, thinking about your own financial goals and needs is better than trying to squeeze out more interest by timing the market.
Use Bankrate’s CD calculator to see how much interest you can earn with a CD.
Is a CD a good investment?
CDs generally provide a safe place for storing savings. You can often calculate how much interest you’ll earn in advance. And by opening a CD maturing in a year or less, you’ll earn more than you would through a standard savings account. Because there are many types of CDs, there’s a good chance you’ll find one that meets your short-term savings needs.
However, a CD isn’t necessarily the best option for everyone or every circumstance. Minimum deposits for CDs are often higher than the ones tied to savings accounts. And it all depends on what you’re trying to accomplish and how quickly you need the funds in your account. If you need the money for an emergency situation, for example, you’re better off keeping it in a savings account or money market account that’s much more liquid.
CD yields are also low compared with what you would earn by investing in bonds or putting your money in the stock market. To earn a higher rate of interest, you’ll have to aim for a riskier investment.
Are CDs safe?
Savers who keep their money in CDs usually have little to lose. At the end of your term, you can expect to get back your initial deposit plus some interest. As long as you keep your money locked up until maturity, you’ll avoid the risk of losing money because of an early withdrawal.
Some types of CDs, however, are riskier than others. With a callable CD, for example, you could begin with a high yield but end up with a lower one if the bank decides to call back your CD in a declining interest rate environment. On the other hand, your CD may not be called if CD rates were to rise, meaning you would still be earning less money than others.
“Callable CDs are a ‘heads I win, tails you lose’ proposition,” says Greg McBride, CFA, Bankrate chief financial analyst. “They exist to benefit the issuer, not the investor.”
How safe it is to invest in a particular CD also depends on the financial institution offering the account. It’s always best to choose a bank insured by the Federal Deposit Insurance Corp. or a credit union insured by the National Credit Union Administration. That way, your deposit is safe if your bank or credit union has to close shop.
There are many different types of CDs. Brokered CDs, for instance, can be found at a brokerage firm and may pay more interest than the CDs available at banks and credit unions. You could also invest in a zero-coupon CD offering a higher face value than what you originally paid. One big downside: You won’t be paid interest until your CD matures, but you’ll still be taxed annually anyway.
Other CDs offer the opportunity to earn a higher yield as time progresses. Through bump-up CDs, you can decide when to raise your interest rate. But with step-up CDs, interest rate hikes happen automatically at certain time periods during the CD term.
You won’t get to bump up your interest rate when you invest in a no-penalty CD, but you will be able to withdraw your savings penalty-free as early as a week after locking up the money. Through an add-on CD, an early withdrawal penalty applies, but you’ll get to continuously add money into the account and take advantage of a yield that’s potentially higher than the one tied to your savings account.
Two additional types of CDs to mention include jumbo and IRA CDs. Jumbo CDs are geared toward consumers with a lot of liquid savings. Minimum deposits usually begin at $100,000 for these accounts. With IRA CDs, you get to put some of your retirement savings in a CD rather than another kind of investment account.
Are you taxed on a CD?
There are several benefits to investing in CDs. One drawback, however, is that you’ll need to prepare to pay taxes on any interest that accumulates over the course of your term (even if you don’t receive any regular interest payments, as is the case with zero-coupon CDs). Taxes have the potential to significantly reduce your earnings. And regardless of whether you keep your money in a CD or high-yield savings account, you’ll be taxed either way.
Taxes are something you’ll have to consider as you’re calculating your savings and setting goals. If you’re transferring interest from your CD into another account, think about setting up a separate account with funds you’ll use to pay your taxes.
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