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By Richard Barrington

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Certificate-Of-Deposit

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.

Compare current CD rates

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:

  • Term

    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:

Standard CD

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.

No-penalty CD

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 CD

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.

Jumbo CD

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.

Step-up CD

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:

  1. 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?

  2. 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.

  3. 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.

  4. 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.

Frequently Asked Questions

Q: Is there any reason I shouldn’t put my money in Treasuries instead of CDs?

A: The contrast between CD rates and Treasury bond yields right now is interesting. CD rates are higher for short-term periods, but once you get to around the two-year mark, Treasury yields start being higher. By the time you get to five-year terms, Treasuries are yielding around 2.30%, while the average CD rate at that length is just 1.58%.

So, does that mean that U.S. Treasury bonds are a viable alternative to CDs for the average depositor? It’s not as clean a fit as you might think, for the following reasons:

  • Trading Treasury bonds in small denominations (certainly, less than $10,000 face value) can be expensive. The upshot is that the yield you see listed may not be the yield you get once trading spreads are factored in.
  • Treasury bonds will fluctuate in price. This can go for you or against you, but be advised that unless you buy and hold a bond to maturity, you might not get the yield you thought you were buying.
  • Bond funds have a couple drawbacks. Bond funds can be a way for smaller investors to get into the bond market, but they carry fees that will chip away at the yield you could be earning. Also, active trading may mean that you never realize the yield you think you’re getting.

A more practical strategy might be simply to shop for the best CD rates. While average five-year CD rates are at 1.58%, the best CD rates at that length are above 2.50%. That’s even better than five-year Treasury yields–and without the complications.

Q: I have $2,500 saved up and am thinking of getting a CD. What should I consider?

A: There are several factors that go into choosing a CD, but the best place to start is deciding on a time frame.

Certificates of deposit require that you lock up your money for a specified time frame. If you need to withdraw your money early, you will probably have to pay a penalty. If you are not sure you can afford to lock up your money, then savings accounts or money market accounts may be better suited to your needs.

If you can afford to lock up your money for a while, then decide specifically how long you can go without accessing this money. This will indicate how long the term of your CD can be. Typically for CD customers, this can be anywhere from a few months to five years. Note that the longer you can commit your money, the higher the CD rate you are likely to get. The downside to a longer CD is that you won’t benefit immediately if market interest rates rise.

Once you’ve decided on the length of the CD you want, shop for the best CD rates at that length. Don’t make the mistake of assuming that CD rates are pretty much the same from one bank to the next — the best CD rates can be significantly higher than the national average, so shop carefully before you commit.

Q: If interest rates are raised, would it be a good time to invest in one of those step-up CDs that let me switch to a higher rate if rates go higher before the CD matures?

A: An opportunity to make a future choice based on prevailing conditions can be thought of as a financial option. An option is a valuable thing, but as with any thing of value, you should expect to pay a price for it. The question is whether or not the price is worth it.

What’s it worth to you?

With a step-up CD, the option to switch to a higher rate in the future often comes at the price of accepting a lower rate initially than you would get on a conventional CD. For example, if the best CD rates for five years were around 2 percent, you might only get a 1 percent rate on a 5-year step-up CD. Therefore, rates would have to rise by 1 percent just for you to draw even with the most competitive conventional CDs, and would have to go even farther for you to make up the ground you lost by starting out at a lower rate initially.

If the gap between the best CD rates and what you could get on a step-up CD were smaller than 1 percent, you would be paying a lower price for the option of raising your rate later on. Knowing that price allows you to better evaluate whether the option is worth it.

Indexed CDs

Indexed CDs are another possibility for a rising rate environment. Rather than giving you a one-time option of stepping up to a higher rate, these adjust automatically to rate conditions based on a specified market index. As with step-up CDs, this feature might come at a price in the form of a discount to conventional CD rates. It also carries the possibility that your rate could go down.

Other rate-changing possibilities

Here are some other deposit account possibilities if you think interest rates are going to rise:

  1. Savings and money market accounts. Rates on both savings accounts and money market accounts adjust periodically to changing rate conditions. The price you pay for this flexibility is that they typically yield a lot less than CDs. However, you can reduce this price by shopping for the best savings and money market rates. The top savings accounts pay about 1 percent these days – better than the average rate on a 5-year CD.
  2. Conventional CD penalties. Rather than exercise a step-up option, you could get a conventional CD and simply pay the penalty for early withdrawal if rates rise. Knowing the size of this penalty would tell you how big a price you would have to pay for this option, though the nice thing about this approach is that you only pay this price if you actually exercise the option.

So, by all means consider step-up CDs as a possible way of preparing for a rising interest rate environment. Just remember to also identify the price you will have to pay in the form of how it compares with competing alternatives. Only by knowing that price can you make a reasonable judgement about whether the option is worth it.

About Author
Richard Barrington has been a Senior Financial Analyst for MoneyRates. He has appeared on Fox Business News and NPR, and has been quoted by the Wall Street Journal, the New York Times, USA Today, CNBC and many other publications. Richard has over 30 years of experience in financial services. He has earned the Chartered Financial Analyst (CFA) designation from the Association of Investment Management and Research (now the “CFA Institute”).