Which Type of CD Is Best for You?
What is the best way of earning interest on savings while keeping them completely safe? In many instances, the answer is a certificate of deposit, or CD.
What is a CD account?
Like savings and money market accounts, CDs are bank deposit vehicles that are typically covered by FDIC insurance when offered by a participating institution. At a time when interest on deposits is pretty meager, the crucial difference is CDs often pay much higher bank rates than savings accounts or money market accounts.
The trade-off is that they lock your money up for a specified period of time, and you typically have to pay a penalty if you access that money before the term of the CD is up.
To decide if a CD is a good choice for your financial needs, the first step is to understand the various different kinds of CDs that are available.
8 types of CD accounts
Here are eight major types of CDs you might encounter in the marketplace:
1. Short term CDs
The amount of time for which you are required to lock up your money in a CD is referred to as the CD's term. CDs are available for a wide variety of different terms, most commonly ranging from one month to five years. Short term CDs typically have terms that are one-year or less so savers would look for rates like 6 month CD rates.
2. Long term CDs
CDs with terms greater than one-year are thought of as long-term CDs. An important characteristic of CDs is that the longer the term, the higher the interest rate they typically pay. Therefore, if you don't expect to need to access your money for a few years, you should consider long term CD rates.
3. Jumbo CDs
Jumbo CDs are CDs for amounts of $100,000 or greater. If you have that kind of money, you might consider a jumbo CD because they often (though not always) pay a little higher interest rate than ordinary CDs of the same length.
4. Variable-rate CDs
While most CDs offer a fixed interest rate over their term, some are designed to vary their rates over time according to changes in a specified market index. This can be an attractive feature if you think market rates are likely to rise, but it can also work against you if they fall. Also keep in mind that CDs with such features often start out at interest rates lower than those of comparable CDs, so rates would have to move significantly in your favor for the variable-rate CD to be worthwhile.
5. Step-up CDs
Rather than changing rates automatically like variable-rate CDs, step-up CDs offer you a limited opportunity to reset your rate if market rates generally rise. Like variable-rate CDs though, the initial interest rates on step-up CDs are often below general market rates, so the opportunity to step-up your rate might only become worthwhile after a large jump in rates.
6. CDs in IRA accounts
While people often refer to "IRA CDs," this is a bit of a misnomer. An individual retirement account is a tax-advantaged savings account that can hold any of a wide variety of investment vehicles, and CDs are among those vehicles.
7. CD ladders
Laddering CDs is a technique by which you invest in a series of CDs with different term lengths. A CD ladder allows a portion of your money to benefit from higher rates on long term CDs while not locking up your entire investment for the long term.
8. Brokered CDs
Brokered CDs are those offered through a broker who can use market knowledge and bargaining power to find you a better interest rate than you might be able to get on your own. Two cautions about this type of product though: Make sure the fee the broker charges does not wipe out the rate advantage they are able to get you, and ensure the CD lists you as the account's owner at a FDIC-member institution, or else your deposit may not be eligible for FDIC insurance.
Note that not all these categories are mutually exclusive. For example, you might find a jumbo long term CD that you can use in an IRA account or as part of a CD ladder.
Shopping for the best CD rates
As you may notice from the above descriptions, the characteristics of various types of CDs have a major impact on the interest they pay. So, for example, when shopping for CDs it doesn't make much sense to compare the rate on a five-year CD at one bank with a one-year CD at another bank.
In order to make an apples-to-apples comparison, start by deciding which type of CD you are interested in. Then compare the interest rates on that specific type of CD from various banks. If you find more than one with essentially identical rates, a secondary point of comparison would be to see which has the least severe early withdrawal penalty, just in case you need to access your money earlier than expected.
Choosing the CD that fits your needs and then shopping for the best CD rates can add significantly to the interest you earn on your savings - and is the best strategy available for fighting back against low deposit rates.
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