If you’re looking for a safe place to keep money that you don’t intend to spend soon, you may want to consider a Certificate of Deposit (CD).
What You Need to Know About CDs
Money expert Clark Howard says that CDs can offer higher interest rates than simple savings accounts and they don’t expose you to the risks associated with the stock market.
In this article, we’ll explain what CDs are. We’ll also cover when Clark says it might make sense for you to get one.
- What Is a Certificate of Deposit (CD)?
- How Are CDs Different Than Savings Accounts?
- When Should I Consider Getting a CD?
- What About No-Penalty CDs?
- How Do I Find the Best CD Rates?
- What Is CD Laddering?
- Is There Anything I Should Do Before a CD Expires?
What Is a Certificate of Deposit (CD)?
CDs are contractual agreements you enter into with a bank. You give them access to your money for an agreed-upon term — typically anywhere from one month to five years. In return, you’re usually able to earn a higher rate of interest than you’d get in a simple savings account. Like savings accounts, CDs are insured by the Federal Deposit Insurance Corporation (FDIC).
Generally, the longer the CD term you select, the higher the interest rate will be. Depending on economic conditions, however, this might not always be the case.
How Are CDs Different Than Savings Accounts?
The biggest difference between CDs and savings accounts is the period of time you agree to have the money locked up. If you open a one-year CD, for example, and need to access your money before that 365 days is up, you’ll typically pay a penalty for withdrawing your money early. In most cases, that penalty will be forfeiting a certain amount of interest (most commonly 90 days’ worth) on your investment.
Simple savings accounts, on the other hand, are open-ended. The bank holds your money for you, but you can withdraw it at any time without penalty.
“You’re stuck in CDs at whatever rate you lock in for one to five years, and to get access to your money early, you have to pay a penalty,” Clark says. “With savings accounts, the interest rate is only guaranteed for a single day. It can change whenever the institution wants to change the rate. But you also have access to your money at any time.”
In many cases, CDs will also require a higher minimum investment than savings accounts, which often have no minimums.
We have a CD interest calculator so you can see how your money will grow during the life of a CD you may be considering.
When Should I Consider Getting a CD?
Clark says that CDs have traditionally appealed to people who are on fixed incomes or are afraid of stocks and looking to earn more money on their savings. But he also says that there are some times when they make more sense than others.
This means looking at the rates for both CDs and savings accounts and the amount of time you’re willing to have your money tied up.
“Generally, I prefer that people have money in savings accounts rather than a CD,” Clark says. “The only exception to that rule is when CDs are earning substantially more interest than a savings account or when interest rates are falling and it looks like they’re going to continue to fall. In that case, money that you don’t need immediately is best placed in a CD.”
Clark’s basic rule of thumb is that he wouldn’t invest in a one-year CD unless the rate was 1/3 of a percentage point higher than what you can get in an online savings account. For a two-year CD, he needs it to be 3/4 of a point higher, and for a five-year CD, 1.5 points higher than the savings rate.
What About No-Penalty CDs?
There’s a specific type of CD called a no-penalty CD that doesn’t play by all of the rules of traditional CDs.
“Occasionally, there will be CD offers where the penalty for canceling your CD before the full term is up is waived,” Clark says. “That can be a way to have your cake and eat it too.”
So, should you consider getting one of those?
“Only if the interest rate on the CD is competitive with what others are offering at the time,” he says.
How Do I Find the Best CD Rates?
Generally, you’ll find the highest interest rates on CDs at online banks. Clark also recommends opening a CD at one of the following discount brokerages:
Most credit unions also offer something called “share certificates” that are similar to CDs. Check with your credit union and you may find rates comparable to — or even higher than — the online banks.
You can use this CD rate calculator to compare how your money will grow at different deposit amounts, rates and time.
Where should you never open a CD? Clark says it best:
“This is a Never Rule,” Clark says. One thing never to do — unless you hate your money — is go to Bank of America, Wells Fargo, Chase or Citibank to buy CDs because they play you for a fool. They place such ridiculously low rates on their CDs. They’re taking advantage of you.”
What Is CD Laddering?
While CDs may sound like a good place to stash your cash, there are some potential cons when you agree to lock your money for a longer period. That’s where the idea of CD laddering can help. Here’s how Clark explains it:
“The concept of laddering in the simplest form is, you take your pile of money you can put into CDs and you divide it into five piles,” Clark says.
“Twenty percent goes into a 1-year, 2-year, 3-year, 4-year and 5-year CD. When the [money from the] first-year CD becomes available after 12 months, you then put it in a 5-year CD.
“That means 20% of your money is always one year or less away from being available to you. But by historical measures, you’ll be earning the highest rates [with the 5-year CDs].”
If you think this strategy is right for you, we have a CD ladder calculator to help you determine the ideal amounts for your financial situation.
Is There Anything I Should Do Before a CD Expires?
There are a few things you need to know before your CD expires. Some CDs are single-term term while others are rollover.
Clark warns: “Do not allow your CDs to rollover in maturity into a new CD issued by your financial institution because they will cheat you. This isn’t a possible cheat you. They will cheat you. It’s in banking 101. When the CD renews, they might pay you a hundredth of that percent interest if you just let it auto-renew. You never do an auto-renew on a CD ever.”
If you have an auto-renew (or rollover) CD, make a note to consider your other options before it auto-renews at a lower rate. For example, you can shop for higher CD rates or move your money into an entirely different account like savings.
Final Thought
CDs are savings tools that are appealing in certain situations. However, it’s important to understand when they make sense for you and when they don’t.
They’re a safe way to store your savings, but they don’t have the potential upside you see investing in the stock market. You know exactly what you’re getting in return for your money, for better or worse.
