One of the best options for locking in a high interest rate — while also reducing the temptation to tap into your savings! — is to open a certificate of deposit (CD).
But keep in mind that CDs have less flexibility than regular savings accounts, and the returns might not be as high as what you could earn investing in the stock market or some other fixed-income options.
Erika Taught Me
- CDs typically allow you to lock in interest rates for a set period.
- You can usually earn more interest with CDs than traditional savings accounts, but CDs have less flexibility.
- If you open a CD, be sure to understand how long you have to keep the money in the account and what the penalties are for early withdrawals.
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How Does a Certificate of Deposit Work?
CDs work similarly to a savings account — you deposit money into it, and your deposit earns interest over time.
The main difference with CDs is that you can only withdraw from the CD after a predetermined amount of time has passed. Usually, if you withdraw early, you’ll owe a penalty or forfeit some of the interest.
Minimum deposit
Some CDs require minimum deposits, which could be just $100 or $1,000 or more.
Unlike a regular savings account, you can't keep adding to a traditional CD once it's opened. You make the initial deposit and then wait for the CD to mature — although you could always open another CD later if you have more money to save.
READ MORE: CD Ladder: What It Is and How You Can Use One to Build Wealth
Earning interest
When you open a CD, you're generally offered a set annual percentage yield (APY).
CDs usually earn compound interest, meaning that as your balance grows (from earned interest), you earn interest on top of that higher balance. Basically, you’re earning interest on interest.
CD rates are typically inverted, meaning a short-term CD usually has a higher APY than a long-term CD. For example, a six-month CD might earn a 5% APY, while a five-year CD might earn a 4.5% APR.
But you'll earn more interest with the longer-term CD by nature of that CD paying interest for a longer period of time, albeit at a slightly lower rate.
If the math is confusing, you can use Erika’s free investing calculator to see how much interest you can earn from a CD (just set $0 for the “additional contributions”).
Term/duration
The CD term, also known as the duration, refers to how long the CD account agreement lasts.
For example, with a six-month CD, you're expected to keep your deposit in that account for six months before withdrawing the funds. A five-year CD requires a five-year commitment.
Typically, if you withdraw funds before the end of the term, you pay a penalty, which usually involves giving up some interest you would have otherwise earned.
The APY is also typically fixed for the whole CD term, so if you lock in a five-year CD at a 4.5% APY, you'll continue to earn interest at that rate for five years, even if the bank lowers interest rates elsewhere.
Maturity
The maturity date is when the CD term ends, at which point you usually have a short window of around seven to 10 days to decide what to do with the funds.
During the maturity window, you could withdraw your money without penalty, or you might choose to roll the funds into a new CD.
If you miss the window, the bank will typically roll the CD over for you.
READ MORE: Are CDs Worth It?
Pros and Cons of CDs
CDs can be a great way to earn interest, but there are some drawbacks to consider too.
Pros
- High interest rates: You can often earn slightly more with CDs than with high-yield savings accounts. That said, the returns generally trail other investments like Treasurys or stocks.
- Fixed interest rates: CDs provide guaranteed interest rates for the whole CD term, which can help if you want to lock in the best rate before interest rates drop.
- Stable principal: The amount you initially put into a CD typically won’t decrease in value. Also, CDs offered by banks and credit unions are insured by the Federal Deposit Insurance Corporation (FDIC) or National Credit Union Administration (NCUA).
Cons
- Limited flexibility: You can't add or withdraw from most CDs as you please. This could be positive though, since it reduces the temptation to withdraw your savings.
- High minimums: Many CDs have higher minimum deposit requirements than traditional savings accounts.
- Penalties: Although you typically won't lose principal if withdrawing from a CD early (although it's possible), you usually have to pay a penalty or give up some interest.
READ MORE: Credit Union or Bank: What’s the Difference?
Types of CDs
There are different types of CDs, with different rules, rates, and other factors. Here are some examples:
- No-penalty CDs allow you to withdraw money before the CD term ends, without penalty.
- Jumbo CDs have high minimum deposits, such as $100,000, but might pay higher interest rates than traditional CDs.
- Step-up CDs let you opt into a higher interest rate once or twice during the CD term if interest rates increase.
- Brokered CDs are sold by investment brokerages and often pay slightly higher rates, but lack a stable value if sold before maturity (they function a bit more like bonds).
FAQs
Are CDs safe?
While all financial vehicles carry some degree of risk, CDs are generally considered safe, especially if they're FDIC- or NCUA-insured, as most are.
With most CDs, you can't lose the amount you put in, so that makes them relatively safe.
Should I let my CD roll over?
Letting your CD roll over depends on whether you want to access those funds between now and when the CD term ends.
It also depends on the interest rate you could get by letting the CD roll over versus how much you could earn by putting that money into other savings accounts or investments.
TL;DR: CDs vs. Other Savings Accounts
CDs are a great way to lock in interest rates for a set period, and you might earn more interest than you could with other savings accounts, including high-yield savings accounts.
However, the returns might not be as high as with bonds or stocks, and CDs usually lack the flexibility to add or withdraw funds as you please.
For more tips on managing your savings, check out these episodes of the Erika Taught Me podcast:
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