5 things to know before opening a certificate of deposit
CDs offer high interest rates but have early withdrawal fees
With interest rates and the cost of living rising, it’s more important than ever to save smartly. Certificates of deposit (CDs) are a safer option than the stock market.
However, in exchange for a higher rate of return on a CD, you must keep your money on deposit with the bank for a fixed period. If you need to access the funds before the term expires, you’ll usually face an early withdrawal fee. This makes a CD less liquid than a savings account.
Additionally, you lock in your interest rate when you open the account. This makes it easy to predict your earnings, but it also means the rate you earn on a CD might not keep pace with inflation.
Even so, there are techniques you can use to combat this risk and still take advantage of the benefits CDs offer. Here are five important things to consider when deciding whether to open a CD.
Key insights
- CDs are a safer option than the stock market, since your returns aren’t tied to an index.
- You may incur an early withdrawal penalty to access your funds before a CD matures.
- The rate you lock into with your CD might not keep up with inflation, but you can combat this risk with CD laddering, or opening multiple CDs with staggered maturity dates.
1. How CDs work
A CD is a type of deposit account that earns a fixed rate of interest for a set period. Both traditional and online banks offer CDs.
You make an initial deposit into the account and can access the funds after the term ends. Tommy Thompson Jr., a certified financial planner with Innovative Financial Group, said, “The most common form of CD pays a stated interest rate in exchange for a holding period of anywhere from three months to two years.” Note that most banks charge a penalty if you need to withdraw the funds before the term is up.
When you set up your CD, you can often choose what you want to do with the interest you earn. You may be able to have the interest earnings stay in the CD or deposited into another account. By keeping the interest earnings in the CD, you’ll benefit from compound interest, meaning you earn interest on interest. However, if you want access to the interest earnings, having these earnings transferred to another account is a good option.
CDs are a low-risk investment to grow your money, but you may be charged a penalty if you withdraw funds before the term is up.
You’ll generally earn a higher interest rate with a CD than with a traditional savings account because your funds are locked in for a set period. By contrast, the interest rate you earn on a savings account changes with market conditions, but you can access your cash whenever you want.
When choosing between a CD and another savings account, Gary Zimmerman, the CEO of Max, which helps people find high rates for their cash, advises thinking about why you’re saving money and when you might need to access it.
For instance, if you’re considering making a large purchase, it makes more sense to keep your money in a liquid savings account. However, “If you have sold a property or business and are reserving cash to pay the taxes on that sale nine months from now, a short-term CD might be right for you,” he said.
Pros and cons of CDs
Keep these advantages and disadvantages in mind when deciding if a CD is right for you.
Pros:
- The interest rate is fixed for the entire term of the CD.
- A government guarantee backs CDs held at FDIC-insured banks.
- You’ll usually earn a higher interest rate with a CD than with a traditional savings account.
Cons:
- Early withdrawal penalties may apply if you access the funds before the CD matures.
- You may get locked into a lower-than-market rate in a rising-interest-rate environment.
- Most CDs don’t allow you to add funds to your account after making the initial deposit.
2. Types of CDs
While traditional CDs are the most popular, there are many other types of CDs you may be able to get. “In recent years, the interest paid by a traditional CD has been so low that banks have created new types of CDs to attract deposits,” Thompson said.
Specialty CD types now on the market include:
- No-penalty CDs (aka liquid CDs): With this type of CD, you can withdraw the money before the term ends without having to pay an early withdrawal penalty.
- Bump-up CDs: If you’re concerned about rising interest rates, a bump-up CD allows you to ask the bank to increase your rate once to match the current rate on CDs with a similar term. Your CD will be fixed at the new rate for the remaining term.
- Step-up CDs: With a step-up CD, your rate automatically increases by a preestablished amount at set intervals (e.g., yearly) during your CD’s term.
- Add-on CDs: One of the disadvantages of a traditional CD is that you can’t add more money to it until the term expires. Add-on CDs solve this problem by allowing you to add extra funds to your CD.
- Jumbo CDs: This type of CD is specifically designed for people who want to deposit large amounts of money (typically at least $100,000). You’ll generally earn a slightly higher interest rate with a jumbo CD than with a traditional CD.
- Index-linked CDs: Most CDs earn returns based on the fixed rate set by the bank. By contrast, returns on index-linked CDs are tied to a specific stock index. While the returns aren’t guaranteed with this type of CD, you may benefit from market appreciation.
3. CD laddering
If you’re concerned about locking up your money for a long period, you can use a strategy known as CD laddering. With CD laddering, you purchase several CDs with different maturity dates. Since your CDs mature incrementally over time, you can access some funds regularly.
When each CD matures, you have options for what to do with the money. If you need some liquidity, you can access it without penalty. Or, if the matured CD had a lower-than-market interest rate, you can combat inflationary effects by reinvesting the funds in a CD with a higher interest rate.
Thompson said: “The most common [CD laddering] strategy is to buy CDs in increments of three months so that every quarter, a portion of savings is available if needed but can be reinvested in a longer-dated CD for a higher interest rate if the capital isn’t needed.”
» MORE: What to do when a CD matures
4. CD rules and requirements
Before opening a CD, consider the following rules and requirements:
- Amount: When you place funds on deposit with an FDIC-insured bank, up to $250,000 is guaranteed by the government. If you want to deposit more than $250,000, you might want to split it up among several FDIC-insured banks to maximize your protection.
- Rate: Each bank's CD rate varies. Before opening your CD, compare rates at several banks to find the best option for you.
- Term length: Although you’ll earn higher rates on CDs with longer terms, you often can’t access the funds without penalty until the term expires. Consider when you might need to use your funds when selecting the term, and only deposit money you won’t need to access soon.
- Minimum deposit: Some banks require a minimum opening deposit of $500 to $2,500 or more.
- Early withdrawal penalties: When you open a CD, you lock in your interest rate for a set period. Since the bank expects to have your funds for the full term, it may charge early withdrawal penalties if you take money out early.
5. Other savings options
While CDs are safe and secure, they’re not always the best option, particularly if you want ready access to your funds. Alternatives include:
High-yield savings account
A high-yield savings account is similar to a traditional one, except it pays you a better interest rate — as much as 10 to 15 times higher than a traditional savings account.
Banks that offer high-yield savings accounts set an attractive rate to earn your business and increase their deposits. It’s a win-win for you and the bank: The bank gets additional deposits when you open an account, and you get a high annual percentage yield (APY).
However, unlike CDs, the APY you earn on a high-yield savings account is variable and changes with market conditions and interest rates.
Money market account
Like traditional and high-yield savings accounts, you can access the funds in a money market account as needed. Plus, many money market accounts have check-writing abilities and debit cards to make access easy.
You usually need to maintain a minimum deposit (e.g., $1,000) to keep a money market account open and avoid paying fees. Plus, the bank may limit the number of transactions you can conduct (e.g., no more than six withdrawals or transfers a month).
Also, money market account interest rates are variable, meaning they fluctuate with changes in the market and economy.
» MORE: Money market vs. CD: Which is right for you?
Treasury marketable securities
The federal government sells several types of Treasury marketable securities. These securities are government-backed, making them some of the safest investments out there. The three most common Treasury marketable securities are:
- Treasury bills (T-bills), short-term securities with terms ranging from four to 52 weeks
- Treasury notes, medium-term securities with terms of two, three, five, seven or 10 years
- Treasury bonds, long-term securities with terms of 20 or 30 years
Like with CDs, the rates on Treasury marketable securities vary with market conditions and term length. Depending on the term you choose, you may be able to earn a rate ranging from around 3.5% to 5.0%.
“Banks love CDs because they typically represent a lower cost of funding and provide banks with greater certainty that funds won’t leave their bank if they don’t remain competitive on interest rates,” Zimmerman said. “But depositors can often earn higher yields by buying T-bills or U.S. Treasury bonds.”
He added: “Depositors sometimes pick CDs rather than bonds due to their simplicity, even though they may not yield as much. When it comes to any deposit product, it pays to shop around for the best rate.”
FAQ
Are certificates of deposit worth it?
Traditional CDs are a relatively safe investment because up to $250,000 of your deposits with an FDIC-insured bank are protected by government insurance. Plus, your account balance won’t decrease. These features make CDs worth it for risk-averse investors.
How do you open a certificate of deposit?
To open a certificate of deposit, start by searching for an FDIC-insured bank to ensure up to $250,000 of your deposits will be government-backed. Next, you can open your account online, by visiting a branch or over the phone.
Once your account is open, you’ll select your CD term, decide how you want to receive interest earnings (e.g., at the end of the term, regularly during the term) and add funds to your CD.
How does inflation affect CDs?
During an inflationary period, CD rates typically increase. Since CD rates are fixed when the account is open, you may be better off choosing a shorter CD term to protect yourself from locking in a lower-than-market interest rate for a long period.
Although shorter-term CDs typically have lower interest rates than those with longer terms, if rates go up during your CD’s term, you’ll have an opportunity to lock in a higher rate when the shorter-term CD matures.
Are certificates of deposit taxable?
You’ll pay taxes at the same rate as your ordinary income on any interest you earn on CDs and similar deposit accounts (e.g., savings accounts, interest-bearing checking accounts).
You must report all taxable interest income on IRS Form 1040. You’ll also need to attach IRS Schedule B to your 1040 if you earn more than $1,500 in taxable interest income.
Bottom line
Before opening a CD, take the time to analyze your savings goals. Although you’ll generally earn a higher rate of return on a CD than other equally safe savings options, your funds will be locked up for a set period. While you can pay an early withdrawal fee to access your funds before the CD matures, it will erode your interest earnings.
For this reason, it’s best to only place funds in a CD that you won’t need to access during the term, like money you’re saving to buy a house. Also, before opening a CD, ensure you’ve built an emergency fund and can easily access those funds if you need them.
Article sources
- IRS, " 1040 (2022) ." Accessed Feb. 1, 2023.
- IRS, " 1099 INT Interest Income ." Accessed Feb. 1, 2023.
- IRS, " Topic No. 403 Interest Received ." Accessed Feb. 1, 2023.
- Office of the Comptroller of the Currency, " What is an index-linked certificate of deposit (CD)? " Accessed Feb. 1, 2023.
- TreasuryDirect.gov, " About Treasury Marketable Securities ." Accessed Feb. 1, 2023.
- U.S. Department of the Treasury, " Daily Treasury Par Yield Curve Rates ." Accessed Feb. 1, 2023.
