Saving 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 into a savings account might mean you miss out on some of the better interest rates.
That’s why you should consider CDs or certificates of deposit. CDs have higher interest rates than traditional savings accounts but are much less volatile than the stock market. They’re a great option if you have a short-term savings goal coming up.
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What is a certificate of deposit?
A certificate of deposit, often called a CD for short, is a bank account similar to a savings account with one exception — you need to keep your money in the CD for a designated period of time. The trade-off? You get a much higher interest rate on CDs than you do on traditional savings accounts.
While a traditional savings account might have 1% to 2% interest, the best CD rates might be over 5%. As long as you keep your money in the account, at the end of your term you’ll have that interest as well.
For example, if you put $1,000 into an 18-month CD at 5% interest, at the end of the 18 months, you’ll have $1,050 in your account.
However, you need to hold the money in the account for the full duration of your term. If you don’t, you’ll pay a penalty. Oftentimes, this will cost you the entire interest you would have earned if the bank doesn’t allow for partial withdrawal.
How to choose a CD
Determining which CD is best for you depends on what you’re looking for.
Your needs are going to be different if you’re saving for a vacation and have 18 months to wait until you need to withdraw the funds, versus if you’re looking at buying a new bicycle and only want to wait three to six months.
When reviewing CD rates, consider the following things:
APY
The APY is one of the most important factors when considering which bank has the best CD rates for you. The APY is the percentage of interest you’ll earn after your CD reaches its term.
Minimum deposit
A minimum deposit is an amount you’re required to put into the bank in order to earn the APY. Generally speaking, you’ll get higher rates with banks that require a larger minimum deposit.
Keep in mind that with CDs, when you put the money into the account, it’s locked in, regardless of whether you add the minimum deposit or more than the minimum. Don’t assume that you can add money to the account later and wait to deposit the full amount as most CDs aren’t set up like that.
Early withdrawal penalty
Another thing to consider is the early withdrawal penalty. A CD might have a great rate, but if its early withdrawal penalty is steep (and some penalties take away all the interest you’re earning), you might reconsider using that account.
Because early withdrawal penalties can be so punishing, you want to make sure you’re in a financial position to lock some money away and have a cushion elsewhere to avoid withdrawing before term. Keeping your emergency fund in a CD might not be the best idea because you’ll need it at unexpected times. It’s better to use CDs for projects you know are coming up but that you don’t need money for just yet.
Safety
Really, the only safety precaution you need to worry about is ensuring the bank you choose is FDIC-insured, so that your money is protected, or NCUA-insured if you choose a credit union.
Otherwise, CDs are a safe and secure way of storing your money, and they’re less volatile than the stock market. That’s why they’re a great choice for savings goals less than five years away. You won’t have to worry about losing money, and you can calculate exactly how much you’ll make by putting your cash in a CD.
The only time when they wouldn’t be considered “safe” is if you have to withdraw your money early. But this is only because you’ll have to pay a withdrawal penalty, which means you might lose out on any potential earned cash.
What’s a CD ladder?
If you want to take advantage of CDs but are worried about potential cash flow issues, then you might consider using a CD ladder.
CD ladders are an investment strategy that requires you to pick out multiple CDs with different maturity dates. With some shorter and others longer, you’ll be able to get higher rates without tying all your money into one account.
With CD ladders, you split your money into different certificates. For example, let’s say you have $5,000 to spend. Here’s how you could ladder it:
- You put the first $1,000 into a 1-year CD with a 4.0% interest rate.
- Then the next $1,000 into a 2-year CD with a 5.0% interest rate.
- And so on and so forth until you’ve put all your money into different accounts, each with an increasing maturity and interest rate.
Each year you’ll have a little money come back to you with interest, and this increases year after year. After the first year, you can find a six-year CD to reinvest the $1,000 because you know the two-year CD is going to mature by next year. Or you can hold it for a rainy day.
And there’s nothing saying that you have to keep the same amount in each CD. You can choose to put more money in accounts with longer maturity dates but higher interest rates to get more bang for your buck.
Pros & cons of CDs
Keep in mind that every bank is going to have its own pros and cons for each CD that you look at. It’s okay to consider several so that you’re making an informed decision.
Don’t just choose the first CD you come across, because that might not be the best place to stash your money for the time being. The APY could be low or the maturation date too far in the future.
Not sure about CDs at all? Here are some general pros and cons of CDs.
Pros
- They’re safe. It’s a safe way to store money and get better rates than a traditional savings account.
- They’re good for risk-averse investors. CD ladders help you take advantage of higher interest rates with less risk.
- You have guaranteed returns. You can pretty much guarantee your returns and calculate how much you’re going to get back.
Cons
- Your money is locked up. Once you’ve deposited money, that cash is untouchable for a specific duration of time.
- Early withdrawal penalties. If you need your money before the CD expires, you pay a penalty that could be so high it cancels out all the interest you’ve made.
- The returns aren’t as good as with stocks. Investing in the stock market will get you higher returns than even a CD ladder will.
Alternatives to CDs
If you’re not sure that CDs are the right option for your money situation, know that there are alternatives, depending on what your needs are.
I Bonds
I Bonds are bonds designed to help you fight against inflation. At the time of updating this, inflation is at over 6% and I Bonds are at 6.89%.
Bonds, like CDs, mature — and you get your money back at the time of maturity. However, unlike CDs, you can sell a bond if you need cash before the bond has matured.
High-yield savings accounts
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 advantage of immediate access to your money.
But keep in mind they still abide by savings account rules. That means you cannot withdraw from the account more than six times a month without being penalized.
Reliable dividend stocks
Dividend stocks are riskier than CDs, but they can be a great way to get a higher APY.
These stocks pay out dividends, a sum of money from the company’s profits, over a set period of time — often quarterly. You’ll also receive market growth with these stocks on top of the dividend profits.
Short-term bond funds
Short-term bonds are bonds that mature in less than five years. They can be issued by anyone, including governments and corporations.
You will either get the growth of the bond once it matures or if you sell it, unlike CDs.
Money market accounts
A money market account is an interest-bearing account at a bank or credit union. Similar to a checking account, money market accounts come with checkbooks and debit card privileges.
However, these accounts aren’t as flexible as checking accounts and each bank may impose its own restrictions. They’ll also typically have lower interest rates than CDs.
Summary
CDs are a great way to maximize your money if you’re not going to be touching it for a short period of time. And with CD ladders, you can reduce your risk by having money mature more often while still taking advantage of high APYs on longer terms.
Overall, CDs are a great way to get a little added interest for money just sitting in the bank — but they shouldn’t be used in place of an emergency fund, because you can be penalized for early withdrawal.
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