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Many CDs earn much higher interest than other types of savings accounts. But the trade-off is that you can't access the money for a long time.
A certificate of deposit, or CD, is a type of interest-bearing bank account where you put some money in and keep it there for a specified time. The longer you keep the money in, the more interest you’ll earn once the CD fully matures.
Compared to other types of savings accounts, CDs typically earn much higher interest – nearly a full percentage point over a savings account from the same bank. Recent interest rates on five-year CDs range from 3.10% to 3.40%.
But you have to be prepared to keep your money in a CD for a long time. Unlike a checking account or savings deposit account, you can’t just spend the money in a CD like cash. Withdrawing your principal from the CD before it matures will incur a large fee, although you can usually withdraw any accrued interest without a penalty.
Still, CDs are an important part of your financial plan. Since their interest is guaranteed, CDs can sometimes outperform riskier financial instruments like stocks.
A CD is only one type of interest-earning bank account. In addition to the traditional savings account, many banks also offer a similar product called a money market account. More and more, you can even find checking accounts that earn interest.
But CDs have many advantages over the other available accounts. That makes CDs worth it when they're part of your financial plan, as they complement other savings products.
Savings accounts span a wide range of interest rates. The worst savings accounts top out at just 0.01% APY. (APY, the annual percentage yield, is the amount you can expect to earn on any one deposit per year.) That means you if you deposit $1,000 in such an account, you’ll have just $1,001 by the end of the year.
However, CDs often earn over 3% APY, especially at online banks. After one year, a $1,000 deposit would be worth $1,030. The following year, as long as your interest rate stays the same, you’ll earn 3% on the full $1,030. That’s called compounding interest.
All interest-bearing deposit accounts earn interest at a stable rate. Certificates of deposit are one of those, as are traditional savings accounts, money market accounts (but not money market funds), and the rare checking account.
That makes CDs a certain source of free wealth for uncertain times. While the stock market has historically averaged a 5% to 8% rate of return, that growth is never guaranteed and could be wiped out overnight by an abrupt turn in the economy. But you’re always guaranteed to earn interest on your savings account, even if the rate occasionally goes up or down.
Since there are so many options for building wealth, CDs may not be the right choice for everyone.
A certificate of deposit earns so much interest because you’re giving money to your bank or credit union to use for many months or even years. This is called the term or maturity period. Before the date of maturity, your bank should let you withdraw the interest without a penalty, but the principal must stay put.
While it depends on your specific bank (or credit union), you’ll have several options to choose from for the maturity period. Nearly all CD products have at minimum a three-month term, but you can also choose CDs from six months to 10 years.
At the end of the term, you’ll be able to withdraw all the cash or roll it over into a new CD with a new term. Any accrued interest will become part of the principal. However, until the maturity date has been reached, you can’t withdraw the cash without being charged an early-withdrawal fee.
While CDs usually have the highest APY of all deposit accounts, you often can only receive the best rates if you agree to lock up your cash for a longer period of time. For shorter-term CDs, the interest rate is comparable to that of a traditional savings account, but the latter provides much more access to the funds.
How your bank or credit union determines the early-withdrawal penalty depends on the bank or credit union. Check your deposit agreement for more information.
Fees for early withdrawal are typically either one of the following:
While no-penalty CDs exist, they have low interest rates and may not be worthwhile if you already have more liquid (accessible) savings accounts.
The minimum deposit is the amount you have to have in your account at any given time to avoid paying fees. Some banks require a minimum deposit when you open the account, but others allow you to open the account and make the minimum deposit later.
The CDs with the best interest rates typically require a higher minimum deposit versus CDs with lower interest rates from the same bank. Banks will often post “balance tiers” in their deposit contracts to determine interest rates. Balance tiers can range from $0 to $25,000.
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A CD is a great way to earn money for doing nothing. You’re guaranteed interest and at a higher rate than other types of accounts.
But there are two things CDs are not so great for: spending money and having a rainy-day fund. To make everyday purchases, you need a checking account. For your rainy-day fund, you should get a high-yield savings account. Even though it could earn less than a CD, the money will be available to you in an emergency.
The certificate of deposit helps you save for long-term goals, such as buying a house. You can save a lot of money on a mortgage by making a down payment of at least 20% of the asking price. A CD can help you reach that 20% given enough time.
While a CD might help you cross the finish line on a home, it shouldn’t be your only option for saving. If you invest in a mix of stocks, bonds, and interest-bearing accounts, you’ll build up a strong retirement plan that can protect you from losing money in the stock market during a period of downturn.
Add in a low-cost term life insurance policy to protect your income if you die and a disability insurance policy to protect your income while you’re still alive, and you’ll have relatively little to worry about financially.
Policygenius’ editorial content is not written by a certified financial planner or advisor. It’s intended for informational purposes only and should not be considered legal, financial, or investment advice. Consult a professional to learn what financial products are right for you.
This post contains references to products or services from one or more of Policygenius' advertisers or partners. While these codes earn us a small fee at no additional cost to you, they do not influence editorial content and we only refer products we love.
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