One of the most important parts of saving money is deciding where to keep your funds, which can be pretty tricky in an oversaturated market. Depending on your savings goals, you may consider opening a certificate of deposit, or CD, if you’re looking for a predictable investment. With a CD, rates are locked in right off the bat, making them low-risk -- but they’re not without their limitations. CDs come with withdrawal penalties and finite liquidity, so you need to consider what matters the most for you and your investment before jumping in.
What is a certificate of deposit?
A certificate of deposit is a type of savings account that pays interest on a fixed deposit for a fixed term, such as six months, one year or five years. CDs tend to have higher interest rates than a traditional savings account but don’t allow easy access to your money. You’ll incur a penalty if you withdraw your funds before the term ends. Keep in mind, however, the longer you leave your money untouched in a CD, the more interest you’ll earn.
How does a certificate of deposit work?
When you open a CD at a bank or credit union, the bank agrees to leave your money on deposit for a predetermined period of time, also known as a term. The term is the time you agree to keep your money in the CD, and you’ll typically see terms ranging from 30 days to 10 years.
When deciding what length of CD term to choose, you should consider your plans for the money. If you’re saving for a specific goal with a known timeline, you’ll want to choose a CD term that matches the timeline. If you want to earn a higher interest rate on your savings and can withstand your money tied up for a while, you may want to choose a longer term.
If you open a CD with a five-year term, you’re promising the bank that you’ll leave your money in the account for five years. Once your CD reaches the end of its term, your CD is considered mature. At this point, you can either withdraw your money or renew the CD.
It is possible to withdraw funds early from most CDs, but you’ll face a steep penalty. The exact penalty will depend on the terms and length of your CD, but early withdrawals tend to eat up any interest earned. There are exceptions with no-penalty (liquid) CDs. Flexibility comes at a cost, however, because liquid CDs typically pay lower interest rates to make room for penalty-free access to your funds.
How do CD interest rates work?
The interest rate associated with a CD is noted as APY, or annual percentage yield. This is the total interest you’d earn on your CD deposit over the course of a year. Like savings accounts, CDs earn compound interest -- or interest on interest. With compounding interest, you’re earning interest off the principal deposit and the increasing interest.
How do certificates of deposit differ from savings accounts?
CDs are different than traditional savings accounts in several ways:
- CDs typically pay more interest than traditional savings accounts. CDs usually offer a higher rate than savings accounts, but they also have a fixed rate of return regardless of whether interest rates rise during the term. CDs offer higher rates in exchange for limited to no access to that money.
- CD rates are fixed; savings account rates fluctuate. CDs are a low-risk investment because they have a guaranteed rate of return. If you open a CD when interest rates are high, your interest rate will remain the same even if the interest rate on a savings account drops.
- You can’t access your money in a CD without facing a penalty. You’ll face a penalty if you withdraw your funds from a CD before the term is up. Savings accounts and money market accounts offer much greater access to your money, though you may be limited to six withdrawals per month.
Should I get a certificate of deposit?
CDs are low-risk investments that guarantee a rate of return. The predictability of CDs makes it easier to calculate what you’ll walk away with because the APY is typically fixed, meaning you’ll earn the same rate for the entire term.
Aside from predictability, CDs are one of the safest places to store cash, as long as the bank is federally insured. Banks insured by the Federal Deposit Insurance Corporation and credit unions insured by the National Credit Union Administration protect your money if your bank goes bankrupt. You’re covered up to $250,000 per depositor, FDIC-insured bank and ownership category.
However, a CD isn’t the best option for every investment. Once your funds are locked in, you can’t take the money out until the term length is over without facing a penalty, making it a risky investment for an emergency fund. Your emergency funds are better off in an account with more liquidity, like a savings account or money market account.
It’s also worth considering the consequences of low-risk investment. Although CDs offer a relatively stable place to stash cash, they have lower yields than you may earn by investing in the stock market. For longer-term investments where you’re seeking higher returns, you may consider investing in riskier assets such as an S&P 500 index fund. An index fund that holds stocks can lose money, so if you’re saving for a short-term goal, it likely wouldn’t be a good choice. However, if you’re saving for a long-term goal, an index fund offers diversification and can perform well over the long term despite the short-term volatility.
You also run the risk of losing purchasing power with inflation. Its possible inflation will rise above the interest rate you earn on the CD. If that happens, your money won’t retain its value over time.
The bottom line
Different types of savings accounts offer different levels of risk and rates of return. CDs come in handy when you’re looking for a low-risk investment, but it’s essential to shop around and see what kind of CD rates and terms different banks are offering before you lock your money away.
Correction, 7:30 a.m. PT Jan. 25: An earlier version of this article incorrectly stated that you can withdraw as much money as you like from a savings account. This statement was unclear in that many banks limit customers to six withdrawals per month from savings accounts and money market accounts. Also, an earlier version of this article included a suggestion that individuals consider investing in higher-risk assets, without the proper context. We added context to include that higher-risk assets can also lose money and that they are better suited to long-term investing, not short-term savings goals.