Saving money for vacations or other short-term goals can be tricky. You don’t want to put that money into the market because it’s too risky, but putting it in a savings account could mean you miss out on some of the best interest rates.
That’s why you should consider CDs or CDs. CDs have higher interest rates than traditional savings accounts but are far less volatile than the stock market. This is a great option if you have a short term savings goal.
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What is a certificate of deposit?
A certificate of deposit, often referred to as a CD for short, is a bank account similar to a savings account, with one exception: you need to keep your money on the CD for a certain period of time. Compromise? You get a much higher interest rate on CDs than on traditional savings accounts.
While a traditional savings account can have an interest rate of 1% to 2%, the best CD rates can range from 5% to 10%. As long as you keep your money in the account, at the end of the term you will also receive interest.
For example, if you invest $1,000 in an 18-month CD at 5% per annum, after 18 months, you will have $1,050 in your account.
However, you are required to keep money in the account for the duration of your term. If you don’t, you will pay a fine. Often this will cost you all the interest you would have earned had the bank not allowed partial withdrawals.
How to choose a CD
Determining who has the best CD rates for you depends on what you are looking for.
Your needs will be different if you’re saving for a vacation and have 18 months to wait until you need to withdraw funds, compared to if you’re looking to buy a new bike and want to wait three to six months.
Consider the following when considering CD rates:
APY
APY is one of the most important factors when considering which bank has the best CD rates for you. APY is the percentage of interest you earn after your CD expires.
Minimum deposit
The minimum deposit is the amount you must put into the bank in order to receive APY. Generally speaking, you will get higher rates at banks that require a higher minimum deposit.
Keep in mind that with CDs, when you deposit money into the account, it is blocked, regardless of whether you made the minimum deposit or more than the minimum. Do not think that you can add money to the account later. Not every CD is configured this way.
Early withdrawal penalty
Another thing to consider is how severe their early withdrawal penalty is. CD might have a great rate, but if their early withdrawal penalty is steep (and some penalties take away all the interest you earn), you might want to reconsider using this account.
Since early withdrawal penalties can be very severe, you should make sure that your financial position will not have access to this money for some time. Keeping your emergency fund on CD may not be the best idea because you will need it at unexpected times. It’s better to use CDs for projects you know are coming but don’t need the money for yet.
Safety
In fact, the only precaution you need to worry about is making sure the bank you choose is FDIC insured so that your money is protected.
Otherwise CDs are a safe and secure way to store your money and are less volatile than the stock market. That’s why they are an excellent choice for savings in less than five years. You don’t have to worry about losing money and you can calculate exactly how much you will earn by putting your money on a CD.
The only time they won’t be considered “safe” is if you need to withdraw early. But that’s only because you’ll have to pay a withdrawal penalty, which means you could lose any potentially earned money.
What is CD Ladder?
If you want to take advantage of the CDs but are worried about potential cash flow issues, you might want to consider using the CD ladder.
The CD Ladder is an investment strategy that requires you to select multiple CDs with different maturities. With some shorter ones and some longer ones, you will be able to access higher rates without having to tie all your money to one account.
With CD ladders, you divide your money into different accounts. For example, let’s say you have $5,000 to spend.
- You invest the first thousand dollars in a certificate of deposit for a period of 1 year with an interest rate of 1.85%.
- Then the next $1,000 in the form of a 2-year CD at 2.5% interest.
- And so on and so forth, until you have placed all your money in different accounts, each with an increasing maturity and interest rate.
Every year you will get back a small amount of money with interest. And it is increasing from year to year. After the first year, you can find a six year old CD to reinvest $1,000 because you know the two year old CD will be mature by next year. Or you can save it for a rainy day.
And nothing says you should store the same amount on every CD. You can put more money into accounts with longer maturities but higher interest rates to get more bang for your buck.
Read more: How to Build a CD Ladder
Pros and Cons of CDs
Keep in mind that each bank will have its pros and cons for each CD you look at. You can consider several to make an informed decision.
Don’t pick the first CD you see because it might not be the best place to store your money at the moment. APY may be low or maturity date may be too far into the future.
Not sure about CDs at all? Here are some pros and cons of CDs in general.
pros
- They are safe. It’s a safe way to store money and get better rates than a traditional savings account.
- They are good for risk-averse investors. CD ladders help you take advantage of higher interest rates with less risk.
- You have a guaranteed return. You can pretty much guarantee your earnings and calculate how much you are going to get back.
Minuses
- Your money is blocked. After you make a deposit, this money will be inviolable for a certain period of time.
- There are penalties for early withdrawal. If you need the money before the CD expires, you pay a fine that can be so high that it cancels all your interest.
- Returns are not as good as with stocks. Investing in the stock market will bring you higher returns than even the CD ladder.
Alternatives to CDs
If you’re unsure if CDs are the right option for your financial situation, know that there are alternatives, depending on your needs.
i bonds
I Bonds are bonds designed to fight inflation. At the time of this writing, inflation and I Bonds were at 7%.
Bonds, like CDs, have a maturity date – and you get your money back at maturity. However, unlike CDs, you can sell a bond if you need cash before the bond matures.
Read more: Everything you need to know about I Bonds
High Yield Savings Account
High yield savings accounts are accounts that offer higher interest rates than regular savings accounts. While their interest rates are lower than CDs, you have the benefit of having immediate access to your money.
But be aware that they still abide by the rules of the savings account. This means that you cannot withdraw funds from your account more than six times a month without penalty.
Read more: Best High Yield Savings Accounts
Reliable dividend stocks
Dividend stocks are riskier than CDs, but they can be a great way to get higher APY.
These shares pay dividends, a sum of money out of the company’s profits, over a set period of time—often quarterly. You will also get market growth with these stocks in addition to dividend income.
Read more: How to invest in dividend stocks
Short-term bond funds
Short-term bonds are bonds with a maturity of less than five years. They can be issued by anyone, including governments and corporations.
You will either get the growth of the bond as it matures, or if you sell it, unlike CDs.
Read more: How does a bond work?
Money market accounts
A money market account is an interest-bearing account with a bank or credit union. Like a checking account, money market accounts have checkbooks and debit card privileges.
However, these accounts are not as flexible as a checking account, and each bank may impose its own restrictions on accounts. They also usually have lower interest rates than CDs.
Read more: Best Money Market Accounts
Summary
CDs are a great way to maximize your money if you’re not going to be touching them for a short period of time. And CD ladders allow you to mitigate some of those risks, as money becomes available after shorter periods of time, while still taking advantage of longer CD maturation times.
In general, CDs are a great way to get a little extra interest on money just sitting in the bank, but they should not be used in place of an emergency fund because you could be penalized for early withdrawals.