When you decide to start building your savings, selecting the best account type can make a big difference in your bottom line. Thankfully, you have two low-maintenance and low-risk options: a certificate of deposit, or CD, and a savings account. These deposit accounts can help you grow a lump sum that can be used for emergencies, such as an unexpected medical bill or a big ticket purchase such as an upcoming vacation.
Although both CDs and savings accounts are easy and inexpensive to open, there’s a trade-off between flexibility and interest rates. Read on to learn more about the strengths of each account type and how to choose between parking your cash in a CD or a savings account.
Savings accounts
A savings account provides a secure place to deposit money and earn interest. You can open a savings account at a traditional bank, credit union or online institution.
As you make deposits into your account, your interest rate (also referred to as an APY, or annual percentage yield) is calculated based on a daily, monthly or annual basis. Each bank sets its own interest rate for its own financial products.
The APY on a savings account is variable and can fluctuate based on market conditions. Many institutions currently offer high-yield savings accounts with interest rates several times higher than the national average, which is currently 0.42% according to the Federal Deposit Insurance Corporation.
Some savings accounts are earning an APY as high as 5% as a result of the Federal Reserve’s attempt to stem inflation with interest rate hikes that started in March 2022. Though inflation is showing signs of cooling, APYs for many high-yield savings accounts remain elevated and are an attractive option for storing cash and earning a decent return.
Why you should choose a savings account
Savings accounts are one way to save your money with limited risk. A savings account might be a good fit for you if:
- You don’t want to risk losing money. While there’s the potential to earn higher returns with an investing account, such as a mutual fund, savings accounts protect against loss. While some investment options will give you a greater return on your savings, they carry far more risk.
- You can accept slower growth. Regular savings accounts at traditional banks earn very low rates of interest -- sometimes as low as 0.01% APY, though there are high-yield savings accounts which may provide up to 3%. The average return on stocks may be significantly higher, but there’s always the risk of loss.
- You want easy access to your money. Savings accounts are highly liquid, which means you can withdraw or transfer funds with a few clicks or at an ATM. With an investment account, you may have to sell stocks or other securities to get cash, which can take days or weeks.
Certificates of deposit
A certificate of deposit, or CD, is another type of savings account. Instead of making deposits at will, however, you make one lump-sum deposit and then leave the money alone for a predefined amount of time, also known as the CD’s term. A term can range from six months to five years and possibly longer, depending on the account.
In some cases, the more you deposit and the longer your term, the higher the interest rate. The interest rate won’t change during that period, but you won’t have convenient access to funds after the initial deposit for the majority of CD options. Though you can make an early withdrawal, there may be a steep financial penalty. When you reach the maturity date, you’ll receive your initial deposit plus any interest that’s accrued.
Why you should choose a CD
A CD encourages long-term growth and mitigates the temptation to withdraw your money. A CD might be right for you if:
- You won’t need the money. CDs encourage you to “set it and forget it.” You won’t be able to easily withdraw your money until the term expires. The longer the term, the longer you’ll wait to get your money plus its interest.
- You want to lock in the interest rate. High-yield savings accounts offer variable APYs, which can go up or down; CDs offer a fixed rate for a set amount of time. If you’re worried about a looming drop in interest rates, a CD can help provide consistent returns even if rates change.
- You want to know exactly how much you’re going to earn. With a fixed interest rate, you’ll know exactly how much you’ll earn at the end of your term -- no guesswork involved.
How CD ladders work -- and when you should use one
You can build a “CD ladder” by simultaneously opening multiple CDs with different maturity dates. When one CD expires, you take your initial deposit and the interest you’ve earned and open another one with a longer term and a higher interest rate. This is what it could look like:
- $1,000 in a one-year CD with a 5% APY
- $1,000 in a two-year CD with a 3.85% APY
- $1,000 in a three-year CD with a 4.5% APY
- $1,000 in a four-year CD with a 3.75% APY
- $1,000 in a five-year CD with a 4.25% APY
After the first year, for example, you’ll take your original deposit plus any interest earned and open a new five-year CD with those funds. The following year, you’ll do the same thing with the two-year CD when it expires. And on and on. Having staggering maturity dates across several CDs allows you to take advantage of fluctuating interest rates while giving you access to a portion of your funds on an ongoing basis.
This is a particularly good strategy for savers who have enough cash to open multiple accounts. Keep in mind, some banks such as Ally don’t require a large initial deposit to open a CD. Starting with one CD and building over time is a valid strategy as well. You can shop around for one that best fits your needs.
CDs vs. Savings Accounts: Similarities and Differences
Availability
Both CDs and savings accounts are widely available at a variety of banks, credit unions and online institutions.
Access
You can deposit into a savings account anytime you want and, in most cases, make up to six withdrawals or transfers per statement cycle. A CD limits your access, meaning your cash could be locked up for a few months or years, depending on the term. After you make your initial lump-sum payment, you usually can’t withdraw it until the CD’s maturity date (and you typically can’t add more to it, either) unless you pay an early withdrawal penalty, which amounts to a period’s worth of interest.
Liquidity
You can take money out of a savings account, or move it to another account, easily and quickly. With a CD, you’ll almost always get penalized for touching it before the maturity date, making it far less liquid than a savings account.
Interest rates
Savings accounts have variable interest rates that change according to market conditions. When the Fed raises rates, your savings account may rise as well. When the Fed cuts rates, your savings rate could follow.
A CD offers a fixed interest rate that will never change over the duration of your term. It’s locked in.
Terms and minimum deposits
CDs can require a larger initial deposit, however, there are banks or credit unions that have CDs with a low or no initial deposit such as Synchrony and Ally. Most savings accounts don’t have a minimum deposit but some do, and especially those that offer more competitive yields.
Should you open a CD or savings account?
While both savings accounts and CDs are both good options for saving money, they have different features. A CD is great if you have a longer-term savings plan that doesn’t require access to your money for extended periods. A savings account may offer competitive rates right now and more liquidity, but rates can change based on market conditions and impact your rate of growth. It’s quite possible that you open both types of accounts to take advantage of the strengths of each one as you work to accomplish your savings goal.
