Certificates of deposit (CDs) are deposit accounts that offer a fixed interest rate for a preset term, which can range from a few months to several years. When the CD matures, you can draw the initial amount you deposited plus interest or roll over the balance into a new CD to keep growing your dough. Here are four reasons to open a certificate of deposit account.
1. You Want to Take Advantage of Higher APYs
In most cases, annual percentage yields (APYs) for CD accounts are higher than traditional savings accounts. Financial institutions pay you a higher rate because you're agreeing to keep your money locked in an account for a set period of time.
Find High-Yield CDs
Generally, the longer your CD term, the higher the interest rate, so there's an incentive to keep your money stashed away for the longer terms. If you have extra savings that you don't need for emergencies or other financial obligations, investing in CDs can offer you a greater return on savings while shielding you from the risk that can come from investing in the market.
Here's a comparison of potential interest earned on a traditional savings account versus a CD account when interest is compounded daily. While it reflects average interest rates at the time of this writing, some CDs currently earn 5% APY or more.
| CD vs. Traditional Savings Account | ||
|---|---|---|
| Savings Account | CD Account | |
| Amount | $2,000 | $2,000 |
| APY | .40% | 5% |
| Savings term | One year | One year |
| Interest earned | $8.02* | $102.53 |
*Interest rates on savings accounts are usually variable. This is an estimate of what you might earn on a savings account if the average rate over a year is 3%.
2. You Have a Chunk of Cash to Save
CD accounts may require a deposit of $500 to $1,000 or more to get started. So, if you have a large sum of money—like money saved up over several years or cash from an inheritance—a CD could be a good place to stash that large sum.
The advantage of making a large deposit into a high-interest CD is that interest accumulates faster on large balances. For example, if you start out with $15,000 in a CD account that earns 5%, you would earn a whopping $1,577 in interest at the end of a two-year term.
Interest on CDs isn't all free money since depositors do have to pay income tax on CD earnings. However, the interest you'll pocket on a large sum might still be enough to achieve a goal such as paying off a credit card or paying a portion of the closing costs if you're saving to buy a house.
3. You Don't Need Immediate Access to Your Savings
CDs tie up your money for a certain time frame, so they're best to use for excess cash you have outside of your emergency fund. If you end up needing to take money from a CD early to pay a bill or other financial obligation, you could get hit with an early withdrawal penalty, which is typically a portion of the interest.
While the early penalty can be a drawback, there's also an upside to it. Knowing you'll have to pay a fee when taking money from the account early could motivate you not to touch CD funds you have socked away for financial goals. Some banks also offer no-penalty CDs that don't hit you with fees for early withdrawals. This type of account could offer you more flexibility if you're not ready to commit to a regular CD.
4. You Want Guaranteed Interest and Deposit Protection
Saving in CDs is a low-risk way to stash cash because the bank guarantees you a set amount of interest as long as you keep the money in the account until the CD matures. In comparison, if you invest excess cash into the stock market, returns aren't guaranteed, and investing in stocks can be risky when you have a short time horizon. If your stock portfolio drops in value without enough time to recover before you need cash, you could end up withdrawing less money than what you put in. With a CD, you may not earn all of the interest possible if you take out cash early, but you're unlikely to lose what you initially deposited.
Another layer of protection CDs offer is deposit insurance, which is a government safety net in place to give depositors confidence when putting money into the banking system. If your money is at a bank that has Federal Deposit Insurance Corp. (FDIC) insurance or a credit union with National Credit Union Administration (NCUA) insurance, the government covers up to $250,000 per account holder. While bank failures are not common, they are possible, and deposit insurance gives you some peace of mind that your money is protected.
The Bottom Line
If you aim to earn as much interest as possible on savings, CDs can provide you with a better return than traditional savings or money market accounts. Seeing what CDs your current bank has to offer and shopping around elsewhere is the best way to find a CD account with a competitive rate and an initial deposit requirement that fits your budget.