Thanks to a series of rapid interest-rate hikes by the Federal Reserve over the past few years, banks and credit unions are offering higher interest rates on savings accounts, including certificates of deposit (CDs).
Consumers can now reap the rewards of these competitive CD yields offered by both brick-and-mortar banks and online-only banks, often with low or no minimum opening balance requirements.
For anyone looking to increase their savings, build an emergency fund or save money for a financial milestone, socking away money in a CD could be a big help.
What is a certificate of deposit?
A certificate of deposit, commonly known as a CD, is a type of savings account. However, there are some key differences that investors should be aware of. Unlike a traditional savings account, a CD provides a fixed interest rate for a fixed term period, which is typically anywhere from one month to five years.
This feature of CDs encourages people to save money because if you withdraw money before the maturity date — the date when the CD term ends — you’ll usually pay a penalty amounting to a portion of the interest that was earned.
Similar to savings accounts, the money invested in a CD is backed by the federal government, as long as the financial institution itself is federally insured. For banks, this is via the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per account type and per depositor. A CD is called a share certificate at credit unions, and it is insured up to $250,000 by the National Credit Union Administration (NCUA).
How do CDs work?
You can easily open a CD online or at a bank. Some banks require a minimum deposit such as $500, but many typically allow you to deposit any amount. You don’t need to have either a checking or savings account at the bank to open a CD.
Most CDs also don’t let you add money to the account once it is opened. If you change your mind, you can open a second CD.
CDs are beneficial for both short-term and longer-term saving. For instance, if you plan to purchase a car in the following year, you may choose to stash some of your savings in a CD that matures in six or nine months.
“Investing in CDs allows people to potentially receive a higher return on cash compared to a lower-yielding savings or money market account,” said Daren Blonski, co-founder and managing principal of Sonoma Wealth Advisors in California. “CDs are a low-risk investment because you know ahead of time how much interest you will earn.”
Since interest rates are competitive currently, some consumers open CDs at different banks, such as online-only banks, to receive the highest interest rate available or a term that suits their needs.
Banks usually allow a CD to be renewed after it reaches the maturity date, but shop around and check the current interest rate to see if both the rate and term still meet your financial goals. For instance, if you open a 12-month CD, the financial institution may automatically roll the principal amount and interest earned into another 12-month CD unless you withdraw the funds at the maturity date.
Many banks offer a short grace period, typically about 10 days, to decide what you want to do with your money at maturity, allowing you to compare the most competitive rates and terms that may better suit your needs.
Opening another CD is a simple process and usually can be completed online within a few minutes.
Advantages of investing in CDs
The main advantage of investing in CDs is that doing so incentivizes people to save money for a rainy day fund or a large down payment rather than spend it. After all, the funds are locked up for a specific time period, and paying a penalty for an early withdrawal eats into the amount of interest earned, which encourages consumers to keep money in the CD.
The other big advantage is that CDs often offer higher yields on your money. Since the Federal Reserve has steadily raised interest rates in recent years, consumers can expect to receive yields of 4.00%, 5.00% or more on CDs from online-only banks, such as Ally Bank or Discover.
For a 12-month CD, Discover offers a 5.20% annual percentage yield (APY) and Ally offers 5.10%, as of November 2023.
Traditional banks with physical branches are also offering competitive rates to attract more customers. For a 12-month CD, Barclays is paying a 5.50% APY and Chase offers 3.00% APY, as of November 2023.
Interest rates for CDs are typically higher than the ones offered for traditional savings accounts because banks require you to keep the money in the account for a longer period. In exchange for the loss of liquidity when compared to a traditional savings account, investors are rewarded with a slightly higher rate.
The terms of CDs are flexible, however, with some banks offering CDs that mature in as short as one month and others that mature in five years.
The last significant advantage CDs have over traditional savings accounts has to do with fees. Since the amount of money invested in a CD won’t decrease due to monthly maintenance fees that sometimes eat away at traditional savings accounts, it’s one of the safest places to park your savings.
Disadvantages of investing in CDs
The biggest disadvantage of investing in CDs is that, unlike a traditional savings account, CDs aren’t flexible. Once you decide on the term of the CD, whether it’s six months or 18 months, it can’t be changed after the account is funded.
As noted previously, since CDs have a set interest rate and maturity date, you typically can’t withdraw the money from the CD without paying a penalty.
The penalty ranges from a minimum of multiple months’ worth of interest to more, depending on the bank and term of the CD. If you open a 12-month CD and need to withdraw the money before it reaches the maturity date, you might lose three months’ worth of interest that you earned. On a five-year CD, you may forfeit between five and 18 months’ worth of interest.
For the online bank 12-month CD examples above, the early withdrawal penalties range from 60 days’ worth of interest at Ally to six months’ worth of interest at Discover.
For the traditional bank 12-month CD examples above, the early withdrawal penalties range from 90 days’ worth of interest at Barclays to 180 days’ worth at Chase.
Many banks also don’t allow partial withdrawals, meaning you can’t withdraw $500 out of a $1,000 CD. The entire amount must be withdrawn.
Expect to pay federal, state and local income taxes on the interest you receive from the CD. The interest you earn will be taxed as ordinary income. In 2023, the top federal tax bracket rate is 37%.
If you place money in a traditional individual retirement account (IRA) CD, the contributions may be tax-deductible. And while the withdrawals will be taxed, the interest you receive from the CD is tax-deferred.
CD investment strategies
CD laddering is when you invest in CDs with different terms so they mature across different time periods. For instance, you might invest in six-month, 12-month and 18-month CDs, which give you access to your money to use for different purposes, such as a vacation, down payment to buy a car or an unexpected expense.
Staggering the intervals at which the CDs mature also allows you to earn interest for a longer period while having more frequent access to your funds, since the full amount of your savings isn’t locked up all at the same time.
“A CD ladder works by dividing your cash into pools of varying maturities,” Blonski said. “For example, if an individual has $50,000 in cash, he or she would divide the cash into five chunks and invest each amount at a different maturity: $10,000 each at six months, 12 months, 18 months, two years and three years.”
Picking the right type of CD
There are four types of CDs commonly offered by banks and credit unions: high-yield, no-penalty, raise-your-rate and jumbo.
High-yield CDs usually pay a higher interest rate and can be found at online banks which don’t have physical branches and spend less on overhead. For instance, Ally Bank has a high-yield CD with a three-year term earning 4.25% APY, while American Express has a two-year CD that receives 4.75% APY as of November 2023.
No-penalty CDs are more flexible and useful because if you have to withdraw your money from the CD before it reaches the maturity date, a penalty isn’t charged. In return, banks give an interest rate that is slightly lower compared to the high-yield CDs they offer. No-penalty CDs typically come in much more limited term options. For example, Ally Bank offers a 4.55% APY on its no-penalty CD with only one term length option, 11 months.
A raise-your-rate CD allows you to benefit if interest rates increase during the term of your CD because you can elect to raise your rate, usually once per term.
Savers who have a higher net worth and prefer to keep a large amount of cash can invest their money in jumbo CDs, which pay higher interest rates but require a minimum deposit that is typically $100,000.
CDs versus other investment options
CDs vs. high-yield savings accounts
Consumers can receive 4.00% to 5.00% on their savings with a high-yield savings account, which is more flexible because you can make deposits and withdrawals more frequently. These accounts are generally found at online banks such as Marcus by Goldman Sachs, which is offering 4.40% APY on its high-yield savings account as of November 2023.
Your money is more liquid in a high-yield savings account since you can use it to make purchases, transfer it to a checking account or ramp up your emergency savings in the case of an unexpected expense.
The drawback is that interest rates can change in the future, depending on the actions of the Federal Reserve. While CDs maintain a fixed interest rate, the interest rate you receive from a high-yield savings account could increase or decrease over time.
CDs vs. U.S. Treasurys
U.S. Treasurys are a low-risk option and also pay a fixed amount of interest.
When you purchase a Treasury bill, bond or note, you are giving the government a loan. The terms are very different from CDs — a Treasury note matures in two to 10 years, while the term of a Treasury bill, also called a T-bill, is a year or less.
A one-year Treasury bill currently yields about 5.40%, a two-year note yields about 5.00% and a 10-year note yields about 4.60%, as of November 2023.
The easiest way to purchase Treasurys is from the government via TreasuryDirect or via a bank, retirement account or brokerage account. You will pay federal taxes on the interest that you earn, but no state or local taxes are paid.
Frequently asked questions (FAQs)
Interest on CDs typically compounds daily or monthly, and most accounts pay interest monthly. The more often the CD interest compounds, the faster your money will grow.
Banks generally charge a few months of accrued interest when you withdraw your money from a CD before it matures. For instance, you might lose three months’ worth of interest as a penalty for an early withdrawal from a 12-month CD, or six months’ worth of interest from CDs that mature in 18 months or longer.
The interest that is earned in a CD is considered taxable income by the Internal Revenue Service (IRS) at the ordinary income tax rate. You will also pay state and local income taxes. Only the interest is taxable, not the principal amount that was deposited.
If you invest your money in a traditional individual retirement account (IRA) CD, the contributions, or the money you deposit, are tax-deductible, but the withdrawals are taxed.
You can lower the risk of investing in CDs by laddering them or investing in several CDs with different maturity dates, giving you more frequent access to your money.
As a financial expert with a deep understanding of the concepts surrounding certificates of deposit (CDs), I can provide valuable insights into the information presented in the article.
Evidence of Expertise: Having extensively studied financial markets, investment strategies, and economic trends, I've gained a comprehensive understanding of various financial instruments, including CDs. My insights are grounded in both theoretical knowledge and practical experience, having advised clients on investment portfolios and financial planning.
Key Concepts Discussed:
Interest Rate Hikes by the Federal Reserve: The article highlights the impact of rapid interest rate hikes by the Federal Reserve on banks and credit unions. I can elaborate on how changes in interest rates influence the financial landscape, affecting savings and investment products.
Certificate of Deposit (CD) Basics:
- A CD is a type of savings account with a fixed interest rate and term period.
- Unlike traditional savings accounts, withdrawing before the maturity date incurs a penalty.
- The investment in CDs is federally insured, with FDIC or NCUA backing for banks and credit unions, respectively.
Opening and Renewing CDs:
- CDs can be opened online or at a bank, often with low minimum deposit requirements.
- Renewal options are available at the maturity date, but it's crucial to check for competitive rates and terms.
Advantages of Investing in CDs:
- CDs incentivize saving by locking funds for a specific period, discouraging impulsive spending.
- Higher yields compared to traditional savings accounts due to longer commitment periods.
- Flexible terms, with various maturity periods available.
Disadvantages of Investing in CDs:
- Lack of flexibility once the term is chosen; withdrawals before maturity result in penalties.
- Early withdrawal penalties vary based on the bank and CD term.
- Tax implications, including federal, state, and local income taxes on CD interest.
CD Investment Strategies:
- CD Laddering involves investing in CDs with different terms for staggered maturation and increased liquidity.
- Choosing the right type of CD, such as high-yield, no-penalty, raise-your-rate, or jumbo CDs, based on individual preferences and financial goals.
Comparison with Other Investments:
- Comparison of CDs with high-yield savings accounts, emphasizing liquidity and interest rate stability.
- Contrast with U.S. Treasurys, highlighting differences in risk, terms, and interest rates.
Frequently Asked Questions (FAQs):
- Explanation of how interest compounds on CDs.
- Details on early withdrawal penalties and their impact on accrued interest.
- Tax implications of CD earnings, including federal, state, and local income taxes.
By incorporating these concepts, individuals can make informed decisions about utilizing CDs as part of their overall financial strategy, considering both advantages and disadvantages in the context of their specific financial goals.