by Tricia Joyce
Everybody knows how important it is to have savings. With money set aside, you can pay for major expenses like tuition, a car, or even a home with relative ease. Savings can also serve as a safety net in times of need and unexpected situations like a pandemic. And more importantly, a healthy amount of savings allows you to head into the future with more financial security. After all, as certified financial planner Gerard Visser recently pointed out to us, it’s never too late to get started on saving for retirement.
There are so many options for savings accounts that it can be overwhelming to choose the right one for you. However, knowing your options is the first step to gaining more control of your future. In this article, we’re going to discuss one type of savings account: certificates of deposit.
What is a CD?
A certificate of deposit, or CD, is a type of savings account that is a time deposit. This simply means that it comes in predetermined term lengths and an expiration or maturity date.
The term lengths vary from bank to bank. It can be as short as 21 days or as long as a decade. The average term lengths that most banks offer fall between 3 months and 5 years. The availability of options for term lengths makes CDs attractive to short-term and long-term investors alike.
What are the pros and cons of CDs?
No withdrawal
With CDs, the main difference from traditional savings is also its biggest disadvantage. As with all time deposits, the catch is that you agree to keep your funds untouched within the duration of the term length. That means you can’t withdraw your money until its maturity date, unlike traditional savings accounts.
Penalty for early withdrawal
If you really need to withdraw from your account, you can — but note that it comes with a fine. How much you have to pay varies per institution, but The Balance warns that it can be subtracted from your initial deposit. If you’re lucky, the penalty will be the interest your account earned. The second case is definitely more favorable because you keep the same amount of money you invested. However, you still lose the interest that makes CDs more attractive in the first place.
Higher interest rate
That said, a CD is generally a safe investment and ideal for people who don’t need immediate access to their assets. The interest is one of its major selling points because the rates are higher than traditional savings accounts. With the magic of compounding, you can earn more interest on interest than you would in a low-yield account. In the context of savings, CNBC points out that compound interest works in your favor compared to compound interest in terms of debt. Next to term length, the interest rate, which is calculated in annual percentage yield (APY) for CDs, is one of the most important considerations you have to make.
Better financial planning
The fixed term lengths and APY can also be useful for financial planning. This is where a CD calculator can be useful. Marcus states that by using a high-yield CD calculator you can find out how much interest you can earn by inputting your initial deposit and term length. Say for instance you deposit $25,000 into a CD with a term length of 12 months. Using Marcus’ APY, you can earn $275 in interest that year effortlessly. Knowing this number can help you more accurately predict your financial outcome and put together a realistic timeline for your financial goals.
What is CD laddering?
If you don’t want to commit to a long-term CD, consider experimenting with a CD ladder. It’s a saving technique wherein you deposit into multiple CDs with different maturity dates. For example, you can deposit $1,000 each into CDs with one-year, two-year, three-year, four-year, and five-year term lengths. This gives you the benefit of high interest rates, meaning better returns, without having to tie all your funds into one untouchable account.
To play it more strategically, Money Under 30 suggests staggering the CDs based on your future needs. Figure out what expenses you have in the future to know how to purposefully use a CD ladder. Factor in, for example, expenses like the college tuition of your child next year or a real estate purchase in the next five years.
What do I do when it matures?
When a CD hits maturity, it enters a short grace period. It’s typically one to two weeks in length and it allows you to withdraw your funds without a fine.
Then, you have three options:
- Deposit your savings into a different (non-CD) account;
- Deposit your savings into a CD account with a different term length; or,
- Automatically renew your account.
If you think a CD or a particular term length is not the right choice for you, the first two options are available. If you didn’t take action during the grace period, banks will automatically renew your account at the same term length. Don’t forget to read the fine print and mark your calendar!
To sum up, a CD is a safe option for short-term and long-term investments. Compared to traditional savings accounts, the returns are higher. Even if you’re only investing for one year, you can earn more in interest. The biggest trade-off is the term length, so carefully consider if a CD, or a particular term length, best fits your needs. If you’re expecting major expenses soon, consider investing in a short-term CD instead or using a CD ladder. The high APY still makes it a better option than traditional savings accounts.
