Which Certificate of Deposit Account Is Right for You?
The first thing you see advertised about certificates of deposit (otherwise known as CDs, or CD accounts) is usually the interest rate. However, there is more to choosing the right CD than just picking the highest rate.
As soon as you start to take a deeper dive into the world of CDs, you realize there are several different kinds of CD accounts.
And while the wide array of choices gives you an opportunity to tailor a CD to your needs, it can also make the choice more confusing.
This article is designed to cut through the confusion by answering the key questions:
- What is a CD account?
- How do CDs work?
- How long do I have to commit to a CD?
- What types of CDs are available?
- How do I choose the best CD investment for my needs?
Once you have answers to those questions, you should be ready to choose the CD account that's right for you.
What is a Certificate of Deposit?
A certificate of deposit is a savings vehicle representing a contract between you and a financial institution. This contract is an agreement to pay you interest according to a specified formula and for a set period, in return for your commitment to leave your money in the CD for the full period.
Basic features of a certificate deposit include:
This is the period of time for which you agree to leave your money in the CD and the bank agrees to the interest formula. Most CD terms are in a range of anywhere from one month to five years, though even CDs with a longer term may be available. The date on which the CD term is due to expire is known as the "maturity date."
- Interest rate
Most CDs have fixed interest rates, so you know how much you will earn over the term of the CD. There are cases where the interest rate is variable, which will be discussed later in this article in the "Types of CDs" section.
- Early withdrawal penalty
With the vast majority of CDs, if you try to take any of your money out before the CD's term is up, you will pay an early withdrawal penalty. This is often based on the CD's interest rate. CDs with longer terms often have the highest penalties.
While CDs are generally perfectly safe, because of the early withdrawal penalty you can lose money in a CD if you take your money out too soon.
- Federal deposit insurance
CDs issued by an FDIC-member bank or an NCUA-member credit union are backed by federal deposit insurance. This covers each customer for up to $250,000 in deposits at any one institution.
Be advised, though, that not all financial products that look like CDs are issued by FDIC or NCUA members, so it is important to check.
In most cases, the great appeal of a CD is certainty. As with a savings account or a money market account, your money should be perfectly safe in a CD. Better yet, though, while the interest rate on savings and money market accounts is subject to change at any time, interest on a CD can be locked in for a specified period of time.
In return for that certainty, however, it is important to be sure you can commit your money for the full term of the CD. Otherwise, you may have to pay an early withdrawal penalty.
CD Terms and Rates
Since getting out of a CD early usually means paying a penalty, why would you lock yourself into a long-term CD?
A big reason is that long-term CDs generally pay higher interest rates. The table below shows national averages for CD rates of different lengths as of December of 2020, according to the FDIC.
|Length of CD||National Average APY|
|1 month CD rates||0.05%|
|6 month CD rates||0.11%|
|1 year CD rates||0.16%|
|2 year CD rates||0.21%|
|3 year CD rates||0.25%|
|4 year CD rates||0.28%|
|5 year CD rates||0.33%|
As the table shows, rates get higher the longer the CD term gets. In fact, the differences in rates are often wider than this table shows.
CD rates vary from bank to bank, with some offering rates much higher than the national average. This can result in even bigger rate advantages for longer term CDs.
Also, interest rates were particularly low in late 2020. In times of higher interest rates, the gap between short- and long-term CD rates is likely to be wider.
Types of CDs
Your choice of CDs goes well beyond different term lengths. Below are explanations of some common CD types:
A standard CD is one with a fixed interest rate, meaning that it does not change throughout the term of the CD. Standard CDs also carry a penalty for withdrawing money before the CD's term is up.
High yield CD
The term "high yield CD" is really just a marketing expression. These CDs have the same features as other CDs, but offer clearly above-average interest rates.
The difference in yield can be significant. As of the third quarter of 2020, the top 1-year and 5-year CD rates were more than twice the average rates for their categories. This shows how shopping for the best rates can really pay off.
A no-penalty CD is one that does not charge a fee for withdrawing money before the CD's maturity date. Even so, your ability to access your account is likely to be limited.
No-penalty CDs are very rare, but it is important to know that CD penalties do vary in size. While the interest rate is likely to be the top consideration in choosing a CD, when all other things are roughly equal, picking a CD with a low penalty can be a smart move.
IRA accounts can be invested in a variety of things, including CDs. However, not all banks offer IRAs - so to invest your IRA in a CD, you should find a bank that offers IRAs and CDs with attractive terms.
When shopping for an IRA CD, be aware that a bank's CD rates for IRAs might differ from its ordinary CD rates. Also, there may be additional fees associated with IRA accounts.
Finally, when you invest in an IRA CD, access to your money is likely to be even more limited than in an ordinary CD. Besides the early withdrawal penalty on a CD, there is also a tax penalty for accessing IRA money before you reach age 59 1/2.
Like high yield CDs, the concept of jumbo CDs is more a matter of marketing language than a clearly defined difference.
Traditionally, the term "jumbo CD" was used to describe CDs for amounts of $100,000 or more. The distinction was made because these CDs often offered a better interest rate in exchange for the large deposit amount.
In recent years, CDs have offered little or no rate advantage for deposits of $100,000 or more. Also, banks that do offer different rates depending on the size of your deposit can set those rate brackets at any dollar level, not just $100,000. So, when shopping for rates, you should be aware that different rates might apply depending on your deposit amount.
While most CDs have the same rate throughout their terms, step-up CDs are designed to increase their interest rates at regular intervals.
A related product is known as a bump-up CD. These are CDs that give you the option to choose a new rate at some point during the CD's term. That way if interest rates have risen since you bought into the CD, you have a chance to reset at a higher interest rate.
Being able to increase a CD's rate may sound good, but what step-up and bump-up CDs have in common is that they both usually start out with rates much lower than more competitive products. This means it would take a large increase in rates just for them to catch up with high-yielding conventional CDs.
Variable rate CD
Instead of a fixed rate, variable-rate CDs have interest rates that are designed to change based on changes in a specific benchmark. That benchmark may be the prime interest rate, inflation or a stock market index.
There are two catches to this, though. Often the base rate of these CDs is much lower than the rate available on standard CDs. Also, the change in interest rate you get may be only a fraction of the change in the benchmark.
How to Choose the Best CD for Your Needs
With all those choices, how do you decide which is the best CD for you?
The best approach is to go step by step, in this order:
- Figure out what you need and when you need it.
Decide on your goals for this money. Is it for use at a specific future date? Do you want to invest it for the long term, earning the best return you can while keeping the money safe? Do you want your investment to be flexible enough so you are not locked into today's rate if interest rates rise?
- Narrow down the type and term of CD you want.
Use your goals to determine the type of CD you should get. If you plan to use the money at a certain time in the future, choose a CD term that matches up with that date. If you are investing for the long term with no specific need in sight, you can choose as long a CD as possible. If you want more flexibility, consider a short-term CD or one with features such as bump-up rate options or a low early withdrawal penalty.
- Compare CD rates.
Only once you've determined the type and length of the CD you want should you compare rates. The idea is to make an apples-to-apples comparison, getting the best rate for a CD that meets your needs.
- Consider additional features.
After you've determined the best rate for a CD that meets your needs, if you have multiple choices that seem equally attractive, you can use other features such as raise-the-rate options or low penalties as tie-breakers.
The wide variety of CD features available can work to your advantage, as long as you understand the choices. Decide what type of CD fits your needs, and then find the best rate you can get for that type of CD.