Americans are currently saving more than ever before. If you find yourself in this situation, you may be sitting on a lump sum of cash trying to figure out where to store it. Perhaps you have some money invested but want to keep cash reserves for an upcoming purchase, like a new car or a down payment on a home. Where, then, should you keep your money?
One option available is a certificate of deposit (CD). Certificates of deposit are financial products typically offered by banks and credit unions. These financial institutions offer a premium interest rate in exchange for you leaving a lump-sum deposit for a set period of time.
In this article, we cover everything you need to know about CDs. We go over what they are, how they work and the benefits and downsides of using them. Though each person’s financial situation is different, we’ll also touch on whether you should use CDs if you carry credit card debt. By the end of this article, you should have a much clearer idea of whether a CD is a viable option to help you reach your financial goals.
A certificate of deposit is a type of savings account offered by banks and credit unions. Banks offer higher interest rates than standard savings accounts in exchange for you leaving your money with them untouched for a predetermined period of time.
Let’s say, for instance, you have $10,000 cash and would like to buy a car in the next year. The interest rate for your traditional savings account is 0.25%. However, your bank offers a CD rate of 1.25% for a 12-month period. Knowing that you’re not going to need this money for another year anyway, you park it in a CD so that you can earn more interest than you would by leaving it in your bank account.
Of course, some stipulations come with CDs. Many lenders require minimum deposits of at least a couple hundred dollars. Additionally, you are not meant to touch the money until after the maturity date, which is the date your CD term expires. Doing so subjects you to an early withdrawal penalty.
CDs work by offering you premium interest rates for a fixed period of time. Account holders lock in funds for a fixed term and can access them again on a fixed withdrawal date.
The interest rates that banks offer often correlate with the amount of time you choose as the term. For example, a short-term CD with a three-month maturity will come with a lower interest rate than, say, a one-year CD. Your bank may offer even longer term lengths, such as five years.
At the end of the term, you have the option to either withdraw your money (your initial deposit plus the interest you earned) or reinvest it back into the CD account.
In exchange for you agreeing to leave your money untouched until the maturity date, banks agree not to change the interest rate. The interest rate for a regular savings account can fluctuate and is often closely related to the federal funds rate.
When you lock yourself into a CD, however, the rates do not change. So, let’s say that you put your money into a CD at the end of 2019. The CD’s term is 24 months. You secured a rate of 2.5%. Shortly after, the federal funds rate dropped to 0.05%. Because you have a fixed interest rate, your bank is required to pay you the 2.5% interest.
This, of course, works both ways. Should the situation be reversed, you’d be missing out on potentially higher returns.
Yes, there are numerous different types of CDs. Below are some of the most common:
- Traditional CD: A traditional CD has fixed interest rates and fixed term lengths.
- No-penalty CD: This CD is like a traditional CD, though you can withdraw at any time without paying a penalty. The rates for these CDs are lower than traditional CDs.
- IRA CD: This is a CD held in an individual retirement account, offering tax advantages.
- Jumbo CD: A jumbo CD has a high minimum deposit amount, often around $100,000. The trade-off is that you receive a much higher interest rate.
- High-yield CD: This is a CD with higher-than-average rates. You’ll typically find these offered by online banks.
- Bump-up CD: Also known as a callable CD, this CD allows you to request a higher rate should market rates rise. There are normally steep minimum deposit requirements, and you can often make this request only once.
- Step-up CD: This CD’s interest rates increase at regular intervals, such as every six months.
- Brokered CD: These CDs are not offered by banks or credit unions but by brokerage firms.
There are a few benefits associated with CDs that could make them worthwhile, depending on your financial situation.
One of the biggest advantages of using a CD is that they are low risk. You know precisely how much you are going to earn in interest each month, and you know the exact amount of money that you’ll have at the end of the term. You don’t need to worry about stock market swings or fluctuating rates of return.
Additionally, CDs are backed by the Federal Deposit Insurance Corporation. Being FDIC insured means your principal and earned-interest payments to date are covered should your bank close. CDs offered by a credit union are insured through the National Credit Union Administration (NCUA).
Typically, CDs offer higher rates of return than regular savings accounts. For instance, Ally, a popular online bank, is currently offering a 0.80% annual percentage yield (APY) for a five-year CD. The APY for its high-yield savings account is currently at 0.50%, though they were as high as 1.8% in October 2019.
If you’re looking to safely store your money for a short period of time, then a CD could be a worthwhile option. You’ll lock yourself into a premium interest rate and earn a bit more than you would by leaving the money in a checking or savings account.
There are a few downsides to consider when using a CD.
CDs can be a tactic for long-term growth, but only if you secure a premium rate. Otherwise, you will be missing out on valuable earnings. The rates of return offered by CDs do not compare with those offered by the market over time, though they don’t come with the risk either.
You also need to be concerned about inflation. Depending on the inflation rate, your money could be less valuable when your CD term expires than when you made your initial deposit.
Unless you are in a no-penalty CD, there are significant liquidity concerns associated with CDs. Once you put the funds away, you should be prepared not to see them again until your maturity date. Though early withdrawal penalties can vary, you’re looking at paying up to 12 months interest as a fee. You will not have this cash available for emergencies or any other purpose.
If you have credit card debt, you may want to look at other options. Credit card debt compounds at high rates of interest. Penalty APRs for credit cards can often reach 27%. The rate of return on a CD will not come close to this. Even if you earned 7% on a CD, which is unheard of, there would still be a difference of negative 20%. In essence, you’d lose money by parking your money in a CD.
Another option is to first pay off your credit card debt using an app like Tally. Tally works to pay off your debt in the most efficient way possible. Once you are out of debt, you can begin building an emergency fund, where liquidity is not a concern. With an emergency fund in place, you may want to explore other savings avenues, like CDs.
If you are sitting on cash that you would like to use to hit certain savings goals, then opening a new CD could be a useful option. CDs provide you with the ability to lock in your interest rate and term length with your bank. You’ll know exactly what your rate of return is, and the rate won’t change through your CD’s term.
The downside to this, of course, is that CDs are not liquid. Should there be an emergency and you need cash, you would need to pay a withdrawal penalty to access your funds. The choice to use CDs ultimately comes down to your risk tolerance and personal financial situation.
However, if you have credit card debt, you may want to pay it off before opening a CD. Because of the high rates of compounding interest on your credit card, you’ll collect more in debt than you would earn from a CD. Even the best rates for CDs do not match the roughly 20% APR you’re charged on credit card interest.
If you have credit card debt, consider a credit card payoff app like Tally.* Once you are out of debt, you can work to build an emergency fund and eventually fund a CD.
*To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. The APR (which is the same as your interest rate) will be between 7.9% – 25.9% per year, and will be based on your credit history. The APR will vary with the market based on the Prime Rate.