Certificates of Deposit (CDs) can offer better interest rates than even the best savings accounts. Unlike savings account deposits, however, the money you hold in a CD will not earn the full advertised interest rate unless you keep the funds deposited for the entire term of the certificate.
What You Need to Know Before Investing In a CD
- What you must know when choosing a CD
- How CDs stack up against other savings accounts
- What to look out for before opening a CD
Rising interest rates makes both bonds and stocks risky for investing.
A certificate of deposit, or CD, offers a low-risk alternative for maximizing interest income over the short-term until more favorable investment choices become available, or for avoiding risk altogether and sleeping better at night.
But is a CD necessarily the best choice for capturing the highest interest rates?
The answer, as with many personal finance questions, is: it depends.
It depends on your financial goals, how comfortable you are with tying up your money in a CD, the length of time you choose to leave your money in a CD, and many other factors.
Let’s break these down so you can make the best investment choice for your financial situation and goals.
- Related: Savings Goal Calculator
What is a CD (Certificate of Deposit)?
A CD, or certificate of deposit, is a savings vehicle that typically pays higher interest rate than a regular savings account as long as you keep your money in the account for a specified period of time (the term). CDs are issued by banks, credit unions, and other savings institutions, and CDs typically include federal insurance up to $250,000 per account, making them virtually risk-free investments.
CDs pay a higher APY (interest rate) for a reason: it's to compensate you the loss of liquidity while invested, which means your money becomes inaccessible for the period of time it's invested in the CD.
How long? Well, it depends on when the CD matures. The most common CD terms are 1, 3, and 5 years.
So if you deposit your money into a 3-year CD, then you’re committing your money to that account for 3 years.
What happens if I need to withdraw the money before three years have passed?
Oftentimes, you’ll have to pay an early withdrawal penalty if you want access to your money before the CD has matured. These penalties vary, but a common benchmark is six months of interest. Ouch.
The main reason to open a CD is to earn the most interest on your savings as possible, without putting those savings at risk of loss.
Okay, now that you know what a CD is and how it functions, let’s look at whether you should invest in a CD.
Do CDs Have the Best Interest Rates Compared to Other Savings Accounts?
In many cases, yes, but there are a few other factors to consider when making comparisons.
First, know that in the majority of cases, the shorter the length of the CD, the lower the APY. Conversely, the longer the length, the higher the APY. Again, it's compensation for the longer illiquidity period.
Second, online banks usually offer the best rates on savings accounts, and this holds true for CDs. According to the FDIC, at the time of writing, a standard 5-year CD has an APY of 1.27%, and there are some online CDs with rates as high as 3.00%. Compare those online CD interest rates to the average 0.10% APY a standard savings account offers, and investing in a CD is a no-brainer.
With these two things in mind, let’s return to the question – do CDs have the best interest rates when compared to other savings accounts?
- Yes, if:
- You’re comparing ‘regular’ long-term CDs against ‘regular’ savings accounts.
- You’re comparing online CDs against ‘regular’ savings accounts.
- You’re comparing long-term online CDs against high-yield savings accounts.
- You’re comparing any CDs against most Money Market Accounts.
- No, if:
- You’re comparing any ‘regular’ CDs against online high-yield savings accounts.
- Possibly, if:
- You’re comparing any ‘regular’ CDs against ‘regular’ high-yield savings accounts.
In general, the interest rate hierarchy from highest interest rates to lowest is as follows:
- Online long-term CDs
- Online high-yield savings accounts
- Online short-term CDs
- Brick-and-mortar CDs and high-yield savings accounts
- Money market accounts
- Brick-and-mortar savings accounts
Hopefully this at-a-glance look at how CDs stack up against other savings accounts helps you figure out where, or if, a CD fits into your financial picture.
If you're still unsure, you can always use our interest rate calculator to see how different accounts stack against each other.
Before we can answer whether now is a good time to open a CD, we need to understand the advantages and disadvantages of committing your money to a CD.
Advantages of Investing in a CD
Unlike regular savings accounts, CDs have fixed, guaranteed interest rates, so it’s easy to figure out what you can expect to earn by keeping your money there, before you commit to it.
Additionally, most CDs don’t have fees associated with them, which means your returns won’t be decreased by hidden fees and expenses. The same can’t be said for other types of savings accounts.
The biggest advantage, as we mentioned before, is that CDs offered by online banks have some of the best interest rates of any savings account out there, so you can be reasonably confident you’re earning the highest interest rates available when you shop from the tables that are updated daily in this article.
One ‘bonus’ to note with online banks is that some offer 10-day guarantees on CDs. This means that if the APY of the CD you selected increases within 10 days of funding your account, you can request an increase to match it. Think of it as a price-match guarantee, except it’s an interest rate match guarantee.
If you are a spender, one advantage of choosing a CD is that your money becomes temporarily inaccessible, so you’re unable to withdraw it to make an impulse purchase (unless you're willing to pay a penalty). Storing your money in a CD can be a good way to force yourself to save, so long as you don’t have an immediate need for the money.
The last advantage we’ll mention is that CDs are federally insured up to $250,000, the same as any other savings account, so you don’t have to worry about losses. Your money is guaranteed. This is especially nice for people who are extremely risk adverse and would prefer not to invest their money in the stock market.
Disadvantages of a CD Investment
While the higher APY makes CDs an attractive choice, you must remember what you’re sacrificing in the process: liquidity. This presents a challenge as far as opportunity cost goes because you have to decide how long you're willing to tie up your money in exchange for pursuing the highest interest rates available.
Additionally, like any savings account, you need to watch out for penalties and minimums.
While you can find some CDs without minimum opening requirements, there are still many that require over $500 or $1,000 to open.
Similarly, while you can find a few CDs that don’t have early withdrawal penalties, the majority do, and it’s important to be aware of that before opening the account.
Therefore, the biggest disadvantage is loss of liquidity which can result in early withdrawal penalties if you need to access your money before the CD matures.
Different Types of CDs
Now let’s look at how you can mitigate the risk of interest rates rising after you commit to a CD.
One easy way to do this is to simply look at opening a different type of CD – one that allows for more flexibility than a traditional CD.
The first type is commonly known as a “bump up” CD, which allows you to request a higher interest rate at least once over the term of the CD. You’re in total control of making this request, so you’ll have to keep an eye on interest rates and make that call when the time seems right.
In theory, this protects you from losing out if interest rates rise. However, if interest rates rise more than once and you can only bump your rate one time, you still run the risk of getting locked in at a lower-than-market rate. Another issue is if you forget to take advantage of a rate bump, you stand to lose even more, as initial APYs with this type of CD are usually lower than fixed-term rates.
The second alternative CD is a “step up” CD. While these two types sound similar, they’re very different. In a step-up CD, interest rates rise at pre-determined intervals. In other words, you don’t have control of when the rates rise.
For example, with a 3-year step up CD, rates may look like this:
- 0.50% initial APY
- 0.75% after 12 months
- 1.00% after 24 months
- 1.25% after 28 months
Like bump up CDs, step up CDs may have lower initial APYs, so even though there’s some flexibility with the APY increasing over the term of the CD, the increase may not be enough to make the option worthwhile.
In other words, these options may be losing bets from the beginning if the initial APY is on the low end and interest rates don’t rise enough over the term of the CD so be careful. In situations where interest rates are relatively stable you may give up more interest on the front than you gain from the step up.
However, if rates rise significantly over the life of the CD then it could really help.
Additionally, be on the lookout for “blended APYs” with regards to step up CDs. This is the weighted average of all the interest rates involved (which is often lower), and it’s what you’ll use to measure against other CDs.
There are also low-or-no penalty CDs available, though they are less common. These might present a good option if you want to have the peace of mind that comes with being able to withdraw your money at any time.
Another Solution: CD Ladders
Since bump-up and step-up CDs are still a gamble (as you might earn less depending on the interest rate you start with and end with), a CD ladder can be a better solution for making sure you consistently earn more, while also making cash available at certain intervals if you need to access it.
Here’s how it works:
You deposit money into multiple CDs that mature at different times. Each time one CD matures, you reinvest (or rollover) that money into longer-term CDs so that you continue to have a variety of CDs maturing at different points in time.
This lowers your risk, as you won’t be tying up all of your money into one CD, and you won’t have to agonize over what term to choose in the first place. Additionally, you’ll increase your chances of scoring a higher interest rate once a CD matures, and if interest rates have decreased, you can put your money elsewhere.
Essentially, CD ladders offer more flexibility and control over your money.
Here’s how a CD ladder works: you might decide to deposit:
- $1,000 in a 1-year CD
- $1,000 in a 3-year CD
- $1,000 in a 5-year CD
Once the 1-year CD matures, you invest that $1,000 into a new 5-year CD, and do the same for the 3-year and 5-year CDs when they mature. Eventually, you’ll end up with three 5-year CDs that each mature two years apart.
Note that you don’t need to invest the same amount across the board; you can invest whatever amounts you’d like into whichever CDs you’d like. You can also choose to place your money into more than three CDs. There’s no right or wrong way to go about this process.
The main point is to ladder the maturities so you're constantly stepping your overall yield toward the highest, current interest rates available. Although maximizing exposure to the highest yields is the primary goal of a CD ladder, they can also be used in retirement or in other situations in which you need to withdraw money on a fixed schedule (typically every year). In this situation, you can construct a CD ladder such that one of your CDs matures at least once a year. At each maturity date, you can withdraw any required cash and rollover the balance into a new CD.
Why Open a CD In the First Place?
CDs can make great savings vehicles for financial goals that fit within a one to five year time-frame.
For example, if you're absolutely certain that you want to save for a downpayment on a house within the next three years, then opening a 3-year CD may help you earn more on your money, thus giving you a bigger downpayment.
The same goes for any planned large expense such as a major home repair, new car, saving for a wedding, a travel sabbatical, or saving towards a class you'd like to take that you're not quite ready for yet.
As always, the main thing to keep in mind is that you won't have access to your money for some time, so it's important to be sure that you're either fairly committed to the goal you're saving for, or that you'll put the money to good use once the CD matures.
So, is Now a Good Time to Open a CD?
Based on the information contained in this article, you should feel more confident about knowing if a CD is the right choice for you. To summarize, there is no definitive “best” time to open one.
A good time to open a CD is when interest rates are on the rise, but if interest rates continue to rise after you open one, you might kick yourself for not waiting a little longer.
Conversely, if interest rates are declining it could make sense to lock in current higher rates for a longer duration CD.
Since trying to time a CD still leads to opportunity cost (and isn’t worthwhile), you can mitigate this risk by using a CD ladder, or by selecting a bump up, step up, or low-or-no penalty CD. Check current rates in this article for your best deal.
It might also be the right time to open a CD if you're uncomfortable with investing your money in the stock market, but still want to earn a decent return. Retirees can make good candidates for this situation.
To wrap up, if you’re okay with the illiquidity in exchange for a higher interest return, and you don’t have an immediate to five-year need for your money, CDs can be an excellent option for your savings, especially when compared to a regular savings account.