Certificates of deposit (CDs) enable you to allocate funds for a predetermined term, accruing interest until maturity. While both banks and credit unions provide CDs, their interest rates may vary.
Hence, are CDs a worthwhile savings option? They could be beneficial if you have a defined financial objective and can secure competitive CD rates.
CD rates are increasing due to multiple rate hikes implemented by the Federal Reserve to combat high inflation. Many banks are now offering CDs with rates around 5%, with some even providing up to 7% for CD specials. However, it’s crucial to bear in mind that CD rates are subject to change based on economic conditions and federal interest rate policies.
Here are key factors to contemplate when determining if CDs could align with your financial goals.
Benefits and drawbacks of CDs
While there are numerous benefits linked to CDs, no savings option is flawless. It’s essential to recognize both the advantages and potential drawbacks of CDs, particularly if you’re unfamiliar with this type of savings instrument. Understanding the pros and cons can be advantageous as you navigate your financial choices.
CD benefits
Before delving into the advantages of CDs, here’s a brief overview of how they operate.
When you deposit funds into a CD, you commit to leaving the money untouched for a specified maturity term, which can range from 30 days to 10 years depending on the CD’s terms. During this period, the bank pays interest to you. Upon reaching the end of its term or maturing, you have the option to withdraw your initial deposit along with the earned interest or reinvest it in a new CD.
Now, let’s explore the benefits of CDs:
- Fixed rates: CDs typically offer a fixed interest rate throughout the entire maturity term, facilitating easy estimation of your money’s growth until maturity.
- Higher returns: Depending on where you open the CD, you may earn more interest compared to a traditional savings account. If you can refrain from accessing the funds before maturity, you stand to earn a considerable amount of interest, particularly when rates are on the rise.
- Safety: CDs are among the safest options for saving money, offering predictable returns, especially when deposited in a Federal Deposit Insurance Corporation (FDIC)-insured bank, which ensures protection of funds up to $250,000.
- Flexibility: CD accounts are available in various terms, enabling you to choose options aligned with your financial goals. Additionally, you can diversify your savings by opening multiple CD accounts with different terms.
Furthermore, there are different types of CDs to consider:
- Raise-your-rate and bump-rate CDs: These allow you to increase your CD rate once or twice during the CD term, advantageous if rates rise after you open your account.
- Add-on CDs: These permit monthly deposits to your account after the initial opening, offering flexibility not typically found in traditional CDs.
- No-penalty CDs: These enable penalty-free withdrawals before maturity, addressing a common CD drawback associated with early withdrawal penalties.
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CD drawbacks
As noted earlier, there are factors that may give you pause when considering saving in CDs. Here are some of the key disadvantages to take into account:
- Access: Unless opting for a no-penalty CD, you’re typically required to keep your funds locked in the account until maturity. It’s crucial to select a CD term that aligns with your financial objectives to avoid choosing one that’s either too short or too long.
- Penalties: Banks may impose an early withdrawal penalty if you withdraw funds from a CD account before maturity. Depending on the bank, this penalty may be a flat fee or a percentage of the interest earned. Generally, the longer the CD term, the larger the penalty tends to be.
- Rates: While banks may offer higher rates to incentivize savers to keep their funds deposited when interest rates are rising, CD rates can decline if economic conditions change. This can diminish their value as a savings tool.
- Lower returns compared to investing: While high-yield CDs may offer decent interest rates, investing in the stock market could potentially yield better returns for your money. However, investing carries greater risk, and there’s a possibility of losing money if your investments do not perform well.
When comparing CD options, understanding how to assess them can be beneficial. While the interest rate and annual percentage yield (APY) serve as a starting point, it’s also essential to consider factors such as CD terms, fees, and minimum opening deposit requirements.
Some banks may permit you to open a CD account with an initial deposit of $0, allowing you to make your first deposit within five to seven business days. Others may mandate an upfront deposit of $500, $1,000, or $5,000 or more. Additionally, fees can accumulate if you need to make an early withdrawal, although you can circumvent penalties by implementing a CD ladder strategy.
CD laddering involves purchasing multiple CDs with varying maturity terms. This strategy ensures that a maturity date is always within reach in case you require a withdrawal. By doing so, you can avoid early withdrawal penalties and potentially capitalize on higher rates by transferring your savings to a new CD with a higher APY.
While CD laddering offers several benefits, it’s important to note that you must be capable of meeting the minimum deposit requirement for each “rung” you establish.
When are CDs a good investment?
Considering saving money in a CD could be a sensible choice if you’re confident you won’t need the funds before the CD matures and you can secure competitive rates. However, it’s prudent to explore other savings and investment avenues to determine the most effective way to utilize your funds.
For instance, you might opt to open a high-yield savings account or a money market account instead. While both accounts enable you to deposit funds and earn interest, there are two primary distinctions: (1) These accounts permit withdrawals, typically up to six times per month, without incurring a penalty fee, and (2) their interest rates are not fixed and may decrease if the economy shifts, unlike CDs, which offer fixed rates.
Regarding interest rates, the comparison typically hinges on where you plan to open your account. While it’s possible to find CDs offering higher rates than savings or money market accounts, it’s important to bear in mind that once you deposit your money into a CD, it becomes effectively locked in.
If you’re seeking the highest returns for your funds, you might consider investing instead of saving. For instance, you could open a brokerage account and invest in stocks, bonds, exchange-traded funds (ETFs), mutual funds, or even cryptocurrency. However, it’s crucial to assess your personal risk tolerance and financial goals before investing.
As a general principle, higher risk often correlates with higher rewards. Conversely, safer investments may lower the likelihood of financial loss. Notably, bank CDs are protected by the FDIC, while credit union CDs are safeguarded by the NCUA, providing an additional layer of security.
CDs can be worth it, but it pays to do your research
Investing in CDs during periods of high rates can yield significant returns on your savings. Evaluating CD rates and terms offered by various banks and credit unions can provide insight into available options and potential returns. Additionally, monitoring fluctuations in interest rates and their impact on CD rates is advisable. Keeping abreast of these trends can assist in making informed decisions regarding CD investments.
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FAQ – Are CDs Worth It?
Q.1 Do CDs make you money?
CDs have the potential to generate earnings through accrued interest on deposited funds. Typically, a higher Annual Percentage Yield (APY), larger deposit amounts, and longer CD terms correlate with greater potential earnings. Saving in CDs represents a method of generating passive income, as your deposited funds work to accrue interest over time.
Q.2 Is CD interest taxable?
Interest earned on CD accounts and other savings accounts is categorized as taxable income by the IRS. Your bank is responsible for providing you with a form detailing the amount of interest earned throughout the year, which must be reported on your tax return.
Q.3 Which bank offers the best CD rates?
CD rates may differ among banks, but typically, the most favorable options are available online. Online banks frequently offer higher CD rates to savers compared to traditional banks, primarily due to lower overhead costs. Additionally, special CDs with above-average rates can be found at credit unions, although meeting membership requirements is usually necessary to join and open an account.