Certificate of deposit: The reliable way to save money and build interest

That’s the basic premise behind a certificate of deposit, often referred to as a CD. This is a common type of savings account that can be a good option for those who want to earn a higher interest rate than what many traditional savings accounts offer. It can also be another way to grow your money without the risk (or reward) of investing in the stock market.  

What is a certificate of deposit?  

A CD is a type of savings account that pays interest in exchange for setting aside money for a fixed period. The interest rate will not change throughout the term of the CD. Once it matures, you’ll have access to the amount you deposited, as well as the interest you’ve earned.  

One big difference between a CD and a traditional savings account is that you cannot touch the money in a CD during the period of the term, or you risk getting hit with a penalty and losing some or all of the interest you’ve earned. 

“A certificate of deposit, or CD for short, is a savings vehicle that’s typically sold by banks to consumers as a low-risk, low-return way to hold cash for a given period of time,” says Scott Sturgeon, CFP, founder and senior wealth adviser of Oread Wealth Partners. “Among a certain set of the population—typically older investors—CDs are pretty popular, but not necessarily as much with younger investors. Lots of factors play into that, but my hunch is that interest rates and the corresponding yields on CDs have historically fallen over time to the point where they haven’t been as great of an allocation of cash recently.” 

The CD’s interest rate depends on the bank and the length of the term you sign up for, which can be a 1-year, 3-year, 5-year term or longer. The longer the term, the higher the APY (annual percentage yield). If you’re looking for a financial vehicle that can earn more than a savings account, but is less risky than investing, opening a CD may be a good fit.  

Most CDs offer an APY that remains the same throughout the term of the CD, but there are CDs out there that offer variable APYs as well. 

How do CDs work?  

To open a CD, either online or through a bank, you can create an account or log in to your account if you’re an existing customer. If you’re a new customer, you’ll need to provide some personal information including your Social Security number to open an account. Then you’ll need to select the CD’s term, which will impact the APY you receive, and finally, you’ll add the amount you want to deposit. Some financial institutions require a minimum deposit, while some may not have any minimums at all. 

The terms available will depend on the bank you choose and can be anywhere from one month to 10 years. Shorter terms typically come with lower APYs, while longer terms offer higher rates.  

Once you deposit funds in a CD account, you keep them there until the term is complete. Once the term is complete or the CD “matures,” you can access the funds as well as the interest paid out on your deposit. If you don’t take action, the term may be renewed, and sometimes at a lower interest rate.  

“You might put $10,000 into a two-year CD with a 2.5% rate. Then you will be guaranteed that 2.5% rate no matter what happens to interest rates and the broader economy, but you cannot access your money until the two-year period is up,” says Anessa Custovic, chief investment officer and investment adviser representative at Cardinal Retirement Planning.

As mentioned before, if for some reason you pull your funds from a CD before it matures, you’ll likely incur penalties. The penalty for tapping these funds early depends on the length of your CD term.  

For example, if you have a term that’s less than one year, the penalty could be up to three months of simple interest. For terms of one to five years, you could pay up to six months of interest on the total amount you end up withdrawing. Aside from that penalty, it’s important to consider the amount of interest you’re missing out on as well. 

Make sure to review the fine print: Federal law sets a minimum penalty on early withdrawals, but it doesn’t limit the maximum dollar amount you’ll be charged. 

Here are the key elements to consider when comparing CDs: 

• Any minimum balance requirements  
• The various terms offered  
• The interest rates offered: Banks typically offer higher rates for longer terms. 
• Potential penalties for withdrawing funds early  
• Any fees associated with the account (You might be able to avoid fees by using a bank, rather than a broker.)  

If you’re able to lock in a solid APY, a CD can earn you more interest than what you might get with a checking or savings account, but with some of the same protections from the Federal Deposit Insurance Corporation (FDIC).  

“Just like deposits in your bank account, CDs are FDIC-insured up to $250,000, so on the spectrum of low- to high-risk investments, CDs are about as safe as you can get,” says Sturgeon. “However, in locking up your money, you’re subjecting yourself to other risks, including pressure from inflation and the opportunity risk of not being able to deploy those funds elsewhere.” 

Pros and cons of CDs  

CDs can be attractive because of the certainty and predictability they offer. On the other hand, CDs tie up your funds for a set period, and you can’t easily access them if you need to. Evaluate the pros and cons before opening a CD account.  

CDs vs. savings accounts

While CDs are a type of savings account, they aren’t one and the same.  

“Whether it makes sense to use a CD or a savings account is largely dictated by liquidity needs and risk. Both are relatively low risk, but with a CD, you’re locking in an interest rate for a set length of time, but also locking up that money as well. With a savings account your interest rate might fluctuate up or down, but you can withdraw those funds at any time,” says Sturgeon.  

CDs offer a sense of certainty in a constantly changing environment and economy. They allow consumers to get a guaranteed rate of return on their deposits in exchange for holding their funds for a set term.  

Savings accounts are also used to put money aside, but they come with more freedom and accessibility since you don’t have to lock away your funds for a set period of time. Savings accounts typically offer a lower APY, but you can take out money on your terms.  

Generally, a CD is good for money that you want to grow but don’t need during the term. A savings account can be used for quick and easy access to funds for emergencies, vacations, and home or car repairs.  

CDs offer more interest for less accessibility, while savings accounts offer less interest for more flexibility. It doesn’t need to be an either/or scenario but rather both vehicles can work together in tandem. 

“It always makes sense to have both a CD and a savings account. Once your savings account is in a comfortable place then the excess is put in a CD,” says Custovic. “You could also use it when it’s earmarked for a specific purchase at a set future time. For example, maybe you know you will be looking at houses in one year. You can put your down payment into a CD to earn more interest on it during that time period.” 

It may also be a good strategy to have both savings accounts and CDs as part of your retirement plan as well.  

“Typically, I recommend retired clients hold around 12 months’ worth of expenses in cash and cash equivalents at any given time,” says Sturgeon. “That might mean three months’ worth of expenses is in their checking account, another three months is in a high-yield savings account, and the remaining six months is tied up in other low-risk investments like CDs, Treasuries, etc. In doing so you’re creating a ‘waterfall of liquidity’ to fund your lifestyle in retirement.” 

The takeaway   

Depending on where you open a CD, the rates may be abysmally low or higher than you might get with a traditional or high-yield savings account. In other words, it pays to shop around to check rates. But before moving forward with a CD, assess your needs and goals to better understand how the term will impact your finances.  

“When it comes to the term of your investment in a CD, it’s important to ensure the amount you’re investing meets your liquidity needs,” says Sturgeon. “That’s because in the event you need to liquidate your CD early, you’re going to pay a decent amount in fees to the point where it would have probably been better to just keep your cash in your bank account to begin with.”