Looking for a more sophisticated way to save your money while taking advantage of higher yields? Then a certificate of deposit might be for you. This type of savings vehicle operates much differently than standard savings account because your money is locked in for a set period of time. On the plus side, you can often find rates that are above average, making your money work harder and grow faster than it otherwise would.
Find out how CDs work, what strategies can help maximize your returns, and how to choose the best one. When used the right way, a smart CD strategy can bolster your savings in a low-risk account.
How a CD Works
A certificate of deposit is a savings account that comes with a fixed interest rate earned on your money. Unlike a regular savings account, however, it also comes with a fixed maturity date, meaning you can’t withdraw funds until a predetermined length of time.
You can choose term lengths ranging anywhere from a few months to several years. The longer the CD lasts, the higher the rate you’ll earn. But if you need to withdraw funds before the CD reaches maturity, you’ll have to pay a penalty on the interest you’ve already accrued.
Benefits of a CD
The most obvious benefit that comes with a certificate of deposit is the higher rate you can receive. Compared to other savings accounts that offer extremely low-interest rates, a CD may be the better option. Some of the best CD rates can be as high as 3%, compared to standard savings accounts that only give you a fraction of a percent. Over time, the difference in interest earnings can really start to add up in your account.
Another advantage of CDs is that they’re extremely low-risk. The APY you agree on with your bank is the same rate you’ll receive for the entire deposit period — there is no variation at all. While a lot of economic changes can occur over a multi-year period, from rate drops to stock market decreases, your money in other investment vehicles could suffer from lower rates.
With a CD, on the other hand, you know exactly what you’ll earn during that time. Plus, CD principals are typically FDIC-insured (or NCUA-insured if you opt for a credit union account). Your money is protected regardless of what happens to the bank while it’s holding your funds.
Disadvantages of a CD
CDs do come with a few disadvantages which are important to understand. The first is that in order to get the most competitive rates, you’ll need to lock in a longer-term, which can last up to five years. This can be a long time to tie up your money, especially since it’s impossible to plan for every potential emergency in that long of a time frame.
If you do need to withdraw funds before the maturity date, you’ll be charged an early withdrawal penalty. Usually, this entails having a certain amount of interest deducted from your principal. In this situation, you don’t lose any of your initial deposit and still earn some interest, just not all of the interest that has accrued to date.
Another downside of CDs is that they oftentimes require a minimum deposit amount, usually between $500 and $1,000. Also, consider what might happen to interest rates while that money is tied up. In the best-case scenario we discussed above, you can benefit from that higher APY if rates drop. But if rates start to increase, your money might be stuck in an account offering a much lower yield than newer options.
How CD Earnings are Taxed
Earnings you receive from certificates of deposit are taxed just as interest is in any other savings account. The difference to note, however, is that you don’t wait to pay taxes when the CD matures. The interest must be reported annually, even if you didn’t make any withdrawals from your account.
Each bank varies on how frequently they apply interest to your account, whether it’s monthly or quarterly. Either way, you’ll receive an annual earnings report from the bank, stating the full amount your CD has earned for the year. That money must be reported as income for your taxes during that year.
Choosing a CD Term
Once you understand how a CD works, it’s time to consider the length of the term. As mentioned earlier, the longer terms between 1 and 5 years have the potential to give you the best possible APY.
But it’s also important to weigh your overall financial needs for the near future. If you know you have a major expense coming up, like a destination wedding or a down payment on a house, you may not want to tie up your cash for that long. On the other hand, a certificate of deposit could help you keep those savings untouched until you’re ready for one of those major life events.
When looking at shorter periods, remember to compare rates for other types of savings accounts. Certificates of deposit don’t necessarily come with the most competitive offers.
Another consideration is to look at seemingly odd term lengths. Some banks offer special deals on CDs for any number of months, like 5 months, 15 months, or 21 months. While it makes for some strange accounting on your end, they may give better rates for these type of promotions.
Options at Maturity
Once your CD matures, you have a few different choices for what to do with your balance. First, you can opt to roll over the funds into a new CD account. This may happen automatically if you don’t take any other action. Usually, the bank defaults to the CD that most closely matches your current term length.
The next option is to transfer your CD funds into an account at the same bank, whether it’s a checking account or savings account. This is easy to accomplish since the funds are staying at the same institution in accounts that already exist.
Your final choice is to request a check so you can deposit the funds at a different bank. If you picked a bank that you don’t use for any purpose other than the CD, this is probably your best option. Just remember to stay on top of your dates so you don’t forget and have your money automatically deposited into another CD.
How to Use a CD Ladder
One strategy for saving through CDs is to create a CD ladder. This is an interesting approach that helps to spread out your money across a variety of CDs that mature in sequential years. To start, you could invest in 1-year, 2-year, 3-year, 4-year, and 5-year CDs. Then every year, you would have one that matures. You can then decide if you’d like to liquidate the cash or roll it over into another CD.
After you start renewing your matured accounts, you wouldn’t roll the 1-year CD into another one with the same term. Instead, you would roll it into a 5-year CD. That puts you on schedule to still have a CD that matures every year, effectively serving as a savings ladder.
Once you get through those shorter-term years, you can take advantage of the higher rate that comes with a 5-year CD but still have cash accessible on a regular basis. It makes your financial planning much more flexible without having to worry about early withdrawal penalties cutting into your returns.
Choosing a Bank for your CD
It’s important to shop around for the best CD offer available because APYs vary greatly across financial institutions. In addition to local banks, consider looking at credit unions as well. You’ll see these called “share certificates” rather than certificates of deposit because members are all part-owners of the credit union.
You can also look at online banks to find the best rates available. You’ll discover quite a bit of diversity, both in term lengths and rates offered. Also, compare early withdrawal penalties in case a financial emergency occurs within the CD period.
Don’t assume that just because you already have a banking relationship for your checking and savings accounts that your current bank has the best CD offers. It’s perfectly normal (and smart) to spread your money across several banks to ensure you get the best deal for each specific type of account you use.
The Bottom Line
Placing your money in a certificate of deposit is a low-risk way to potentially take advantage of higher interest rates. As always, it’s important to compare different APYs and term lengths so you can create a savings strategy that makes sense for your financial goals.
If you’re ready to get a little more sophisticated with your savings plan, consider a CD ladder. While it takes a couple of years to really get it going, this could be an advantageous way to access the best interest rates possible while keeping the opportunity to make a withdrawal each year without being penalized.
