CDs or Savings Accounts in Today's Interest Rate Environment?

A reader recently asked me why open a CD when rates are so low. Wouldn't an internet savings account be better until rates are higher?

Last year at this time many had thought we would surely see higher rates in 2010. In July 2009 there were a few savings accounts with a 2.50% APY. The best 1-year CD rate was 2.50% APY, and the best 5-year CD rate was 3.91% APY.

For the last year rates have continued to fall. In July 2010, the best savings accounts without balance caps have rates of only 1.50% APY.

As you can see in the rate history for the last year, it's hard to predict future interest rates. So you may not want to put all of your bets that interest rates will soon rise.

That's one nice aspect of CD ladders. You don't try to guess future interest rates. Once your CD ladder has been active for a while, you just replace maturing CDs with new CDs without regard to the interest rate environment. If rates stay low, those CDs opened this year will do better than if that money was put into a savings account. If rates do rise, you can take advantage of the higher rates as your CDs mature.

I reviewed some alternatives to the traditional CD ladder in this post on the Best Strategy for Your Savings. Reward checking and savings accounts are alternatives, but they have downsides. Another way to improve a CD ladder is by choosing CDs with small early withdrawal penalties. If rates do go up substantially, you don't have to wait for the CDs to mature to take advantage of higher rates. If the early withdrawal penalty is small enough, it can be worthwhile to break the CD, and reinvest the amount into a new higher-paying CD. An example of such a CD is the 5-year CD at Ally Bank that currently has only a 60-day early withdrawal penalty (see review).

Has this low interest rate environment changed how much in CDs you hold? What percentage of your savings do you have in CDs? Please let us know in our poll (a new feature that we recently added).