Note: This article is part of our Basic Banking series, designed to provide new savers with the key skills to save smarter.
Despite the Fed cutting rates again recently by a quarter percentage point and market interest rates declining, CDs are worth it right now. Still, there are several factors to consider to determine whether it’s currently your best deposit account option.
When it comes to saving your money, your three main options are savings accounts, money market accounts and certificates of deposit (CDs). Savings accounts and money market accounts work similarly in that you can transfer money in and out of them, up to a limit. Both have variable interest rates, meaning rates fluctuate over time. Money market accounts usually offer higher rates than savings accounts, though you may face more fees.
CDs, on the other hand, have fixed interest rates. Additionally, when you put money into a CD, you can’t withdraw it for a certain time period without paying a penalty. While savings accounts and money market accounts are ideal for emergency funds or short-term savings goals, CDs make more sense for slightly longer term savings goals, particularly when rates are falling.
When are CDs worth it?
There are a couple of instances when saving your money in a CD makes the most sense:
When interest rates are falling
When you open a CD, you’ll lock in a fixed interest rate. This differs from the interest rate on a savings account or a money market account, which is variable and may go up or down over time.
If rates are falling, like they are now, it may make sense to lock in a higher rate with a CD. However, be cautious of locking up too much of your money for a long period of time in a CD, as you’ll have to pay a penalty if you withdraw it before your maturity date.
When you have a concrete financial goal
CDs also make sense if you have a specific financial goal you want to meet. “Let’s say you want to buy a house in five years,” said Travis Gatzemeier, a financial planner and founder of Kinetix Financial Planning. “A 5-year CD could be a good choice.”
With a CD, you can protect your money until it comes time to buy a house and ensure you don’t spend it, while potentially earning a higher interest rate than you’d be able to with another deposit account. Note that to earn the highest CD rates, you’ll want to invest in a longer-term CD, like a 6-year CD.
What are the biggest advantages of a CD?
The most noteworthy benefits of CDs include:
- Potentially higher interest rates than other deposit accounts:Since you can’t take your money out of you CD before the maturity date without paying a penalty, you may be able to earn a higher interest rate on a CD compared to a savings account, for instance.
- Predictable returns:Thanks to its fixed rate and fixed term, you’ll know exactly how much you’ll earn over the duration of your CD.
- Low risk: If you want to invest your money, but also want to ensure your investment pays off, a CD is a great choice — you’re guaranteed to get your principal back, plus earn interest.
When are CDs not worth it?
You may want to move away from CDs and consider other options in the following instances:
When interest rates are rising
When interest rates on savings accounts and money market accounts are on the rise, locking in a fixed interest rate with a CD may not be the best financial move. You’ll face interest-rate risk because you’ll be missing out on potential gains that you may be able to earn if you put your money elsewhere.
In a rising interest rate environment, for instance, a money market account may offer the chance to earn more as rates continue to increase.
When other account types offer higher rates
After you do some research, you may come across a savings account or money market account that offers a higher interest rate than a shorter term CD. In this case, it would be better to opt with another account, as you’ll earn more interest.
Additionally, going with another type of deposit account will allow you to access your money whenever you want without paying a penalty.
What are a CDs biggest disadvantages?
The biggest drawbacks of CDs are as follows:
- Limited liquidity:If you put your money in a CD, you won’t have the freedom of withdrawing it any time you please without paying a penalty. In most cases, the early withdrawal penalty depends on the financial institution and the length of the CD, but can range from a few months to a year of interest.
- Lower payouts that other financial products: Although CDs may offer more favorable yields than other liquid deposit accounts, you could get lower returns than you may otherwise get if you invested your money in another product, such as an annuity.
- Inflation risk:The rate of return on CDs may not keep pace with the inflation rate, which means you may lose purchasing power over the long term.
The best deposit account rates are with long-term CDs
Typically, the highest yield available with an insured deposit account is with a long-term CD. If you look at this example of the average CD terms and rates, you’ll notice that interest rates become higher as the terms become longer.
Of course, the longer your CD term, the more time you’ll have to keep your money locked up so you shouldn’t put all your money into a long-term CD. It’s a good idea to have an emergency fund or other places you can depend on for easily accessible cash in the event you need it.
How to build a CD ladder
Fortunately, some of the shortcomings of CDs, like limited liquidity and interest rate risk, can be addressed with a CD ladder. A CD ladder is a strategy where you divide the amount of money you’d like to invest into equal amounts in separate CDs with different maturity dates.
For example, if you have $10,000 in cash, you would open up five separate CDs at one time on a staggered schedule. Here’s what it may look like:
- $2,000 in a 1-year CD
- $2,000 in a 2-year CD
- $2,000 in a 3-year CD
- $2,000 in a 4-year CD
- $2,000 in a 5-year CD
Every year when a 1-year CD matures, you’d renew it and convert it into a 5-year CD. Since 5-year CDs pay out at a higher rate than shorter-term CDs, this strategy would allow you to keep your money in the highest-earning CDs and get the most bang for your buck.
“If you want to buy a house in five years, and want to spread your risk because you’re not sure if rates will rise or fall, you can do a CD ladder,” said Gatzemeier. “[It can give you] peace of mind because your funds won't be locked up in one rate.”
Building a CD ladder takes a bit more effort, and you have to stay disciplined enough to take your proceeds and roll it into the next CD cycle rather than just taking the money and spending it. However, the extra effort and discipline can be worth it.
Since interest rates are currently falling, a CD may be worth it right now. This is particularly true if you build a CD ladder, as going this route can maximize your yield. Of course, it’s important to consider your current financial situation and future goals before putting your money into a CD or any other type of deposit account.