Certificates of Deposit (CDs)
Updated on March 20, 2019
Interest rates on traditional savings accounts can be almost nonexistent. While high-yield savings and money market accounts serve as great alternatives, a certificate of deposit (CD) could be an even better one.
What Are CDs?
Certificates of deposit, also known as CDs, are savings accounts that typically have higher interest rates than both high-yield savings accounts and money market accounts. This is because they have one small catch: you won’t be able to touch your money until after a set amount of time.
This time is called your “term length” and will be chosen by you. Generally, the longer the term you choose, the more interest you’ll earn. Banks typically offer CDs that range between terms of 1 month to 5 years. Since you are rewarded for choosing longer terms, 1 month CDs will have the lowest interest rates while 5 year CDs will have the highest.
Early Withdrawal Penalty
Before choosing the term for your CD, you’ll want to make sure you can leave your money untouched for that long. If you withdraw your money before the term is up, you’ll typically be charged an Early Withdrawal Penalty. Early withdrawal fees can amount to months of interest so choose your term whyzely or stick with a high-yield savings or money market account if you think you might need your money before the term is over.
After you decide the best term length for your CD, you will deposit your money and leave it untouched until the end of your term. The last day of your term is called the “maturity date”. Once your “maturity date” is met, you can either withdraw your money plus the interest earned or reinvest it into another CD. If you choose to do nothing, your money will automatically be placed into a new CD with a similar term as your last one.
While most CDs have a fixed term length and a set APY, some banks offer CDs that operate a little differently.
- Bump-up CDs. These CDs allow you to request higher APY rates if the bank increases them after you open your CD. Typically these CDs will start with lower interest rates and you’ll only be able to “bump-up” your APY once or twice.
- Step-up CDs. Allow you to raise your APY at specific times during your term. For instance, if you a 2 year step-up CD, your bank will allow you to raise your APY after the first year.
- No Penalty CDs. The CDs give you the ability to withdraw your money, penalty-free, before the end of your term. In exchange for this flexibility, you will typically receive a lower APY.
- IRA CDs. These are regular CDs that can be bought within your individual retirement account (IRA).
- Jumbo CDs. High minimum balance CDs. The required minimum balance can be around $100,000. Typically they have higher APYs than regular CDs.
Using A CD Ladder
If you like the high interest rates of a 3 to 5 year CD but are wary of not being able to touch your savings for that long, you’re not alone. You can overcome this dilemma by using a CD Ladder strategy. This strategy involves dividing your money over multiple short and long term CDs instead of just buying one long term CD.
Three Year CD Ladder
As an example, let’s say you have $15,000 and are looking to build a three-year CD Ladder. Your first step would be to divide this money evenly and invest $5,000 into three different CDs. $5,000 into a one-year CD, $5,000 into a two-year CD, and $5,000 into a three-year CD. The next year, you would reinvest the money from the one-year CD into a three-year CD. The year after that, you would reinvest the money from the two-year CD into a three-year CD. You repeat this again the next year for your last CD, reinvesting the money from your three-year CD into another three-year CD. Now you have your ladder set up. At this point, you’ll have the option to cash out or reinvest a CD every year.
Five Year CD Ladder
Using the same example, let’s say you have $15,000 and are instead looking to build a 5 year CD Ladder in order to get higher interest rates. Your first step again would be to divide this money evenly and invest $3,000 into five different CDs. $3,000 into a one-year CD, $3,000 into a two-year CD, $3,000 into a three-year CD, $3,000 into a four-year CD, and $3,000 into a five-year CD. The next year, you would reinvest the money from the one-year CD into a five-year CD. The year after that, you would reinvest the money from the two-year CD into a five-year CD. You would then repeat this cycle until you reinvested the money from your original five-year CD into another five-year CD. Now you’ll have your ladder set up. At this point, you’ll have the option to cash out or reinvest a CD every year but with higher interest rates than the three-year ladder.
Things To Compare
Whether you decide to buy one CD or start a CD Ladder, you’ll want to compare these key details.
Annual Percentage Yield (APY)
The most important detail is how much interest you’ll make. This will be shown as an Annual Percentage Yield (APY). APYs reveal exactly what percentage of your money you’ll get paid in interest over the timespan of a year. The APY for a CD with a term longer than a year shows you how much interest you will make each year until your term is complete.For instance, if you deposited $10,000 into a three-year CD offering 2.5% APY, you’ll earn $250 in interest the first year, $256.25 the second, and $262.66 the third year if you leave your money untouched.
Another detail you should compare is the minimum balance required to open a CD. Depending on the bank or credit union, minimum balances can range from $1 to over $10,000. Although, CDs with higher minimums tend to have higher APYs.
Account fees should also be a major factor in choosing your money market account. Fees can easily wipe away your interest and should be avoided or minimized when possible. When comparing banks, you should focus on these common fees:
- Monthly Maintenance Fees. Some banks charge monthly maintenance fees just to maintain your account. Luckily, these fees can typically be avoided.
- Outgoing Wire Transfer Fees. Unfortunately, most banks will also charge you a fee each time you wire funds from your CD to another account. Although this fee is usually not avoidable, the amount varies between banks so you should still attempt to minimize it.
Ultimately, if you’re looking to earn more interest on your savings and can afford to let your money sit untouched, then CDs might be your best option. As you look to grow your savings with this type of account, make sure you compare the key details and choose the one that best suits your needs and timeline.