Mapping out plans to build your savings can be challenging, especially when interest rates fluctuate. A certificate of deposit (CD) is a good alternative if you’re risk-averse when it comes to investing.
A CD is a type of savings account that allows people to earn interest at a fixed rate often higher than what’s available with traditional savings accounts. However, CDs can also have some downsides given the requirement of holding funds for a set term. These are a few things to consider for those weighing if a CD is right for them.
How does a CD work?
With a CD, you get a fixed interest rate for a fixed period. After the CD’s term is up, you’ll have access to the deposited funds and interest earned.
According to Brad Stark, certified financial planner and co-founder of Mission Wealth, a wealth management firm in Santa Barbara, California, you can purchase CDs in brokerage accounts to help with simplicity. Many brokerage firms, such as Fidelity, have relationships with different banks, allowing people to spread their money around without opening various accounts.
By buying CDs, Stark explains that people are essentially making a promise with a bank. That promise is providing funds to an institution in exchange for being paid back with interest later.
“It’s a loan you’re making to the bank for a set period of time,” Stark says.
Pros of a CD
CDs are appealing for many reasons: they’re relatively safe investments, offer stellar APYs, and come in a variety of different term lengths.
Higher APY than other types of savings accounts
While it’s true that you’ll get a higher annual percentage yield (APY) with a CD versus a traditional savings account, it’s important to consider timing or when you plan to open a CD. If you open a CD when the federal funds rate—or the Fed’s benchmark rate—is low, you won’t rake in as much interest as you would if interest rates were higher.
Another factor you’ll want to pay close attention to is your investment time frame.
“As you commit your money to longer periods of time to lock it up, you should be compensated with higher interest,” Stark says.
However, this doesn’t always hold true. Right now, the yield curve is inverted so most longer-term CDs are offering higher APYs than shorter-term ones.
Your money is safe
If you open a CD or share certificate at a bank or credit union that’s insured by the Federal Deposit Insurance Corp. (FDIC) or National Credit Union Administration (NCUA), respectively, you’re insured up to $250,000 per depositor, per financial institution in the unlikely event of a bank failure.
Flexible account options and a wide selection of terms
CDs have durations ranging from a few weeks to many years, so you’ll want to choose one that matches your investment horizon—whether it’s for a down payment years down the line or cash you need in one year.
As of January 2024, the national rate for a 1-year and 5-year CD is 1.86% and 1.41%, respectively. While these rates aren’t stellar, you can find CDs that boast generous APYs by shopping around.
These financial institutions often offer rates above 5%:
CD laddering
One method to consider is placing money in multiple CDs rather than just one; this is known as a CD ladder. Scott Van Den Berg, a CFP at Century Management, says building out a portfolio of CDs can have major benefits.
Here’s how it works: You split your cash up between multiple CDs of different term lengths and when they mature, you reinvest the money into new CDs. This helps create a cascade of liquidity, with each CD maturing at a different time. With the extra liquidity, you can deal with unforeseen expenses more easily without tapping into your money early.
“[CD laddering] gets you that money back, and you can then just reinvest it,” Van Den Berg says.
Cons of a CD
CDs aren’t the right choice for everyone. CDs may offer little liquidity, meager returns, and no tax benefits.
Returns aren’t as high as investing in other places like stocks or bonds
CDs can be a way of playing it safe. By opting for a CD over a more lucrative yet risky asset like stocks, there’s an opportunity cost. This is particularly important to consider if you haven’t reached retirement age. “If you're 85 or 90 years old, you want all your money to be safe and your time horizon is really short, you could put CDs in an IRA [individual retirement account],” Stark says. “If you're 40 years old, and you have an IRA and CDs in there, what an opportunity you're missing.” Plus, the time agreement of a CD can be inconvenient if someone is unable to hold the funds there for the duration of the agreement.
Both Stark and Van Den Berg noted other areas where it’s possible to have stronger investment growth than with a CD, like stocks and bonds.
Stark suggests considering stocks in a diversified portfolio if the time horizon for your financial need is longer than 7–10 years. “While this path is volatile, time tends to heal most short-term investment wounds,” Stark says. “Where time is the enemy to CD investing.”
Inflation isn’t factored in with a locked APY
Whenever you invest in a CD, you lock in the interest rate for the term. If inflation rises during the term, your APY won’t be adjusted, so an interest rate that once seemed stellar might be lackluster after accounting for inflation.
“Inflation really took a toll on you and your interest went from double digits to zero,” Stark said. “In the meantime, prices … went higher so your purchasing power just got decimated.”
Taxes owed on accrued interest
You’ll have to pay federal and state income tax on interest you earn on traditional CDs. If you’ve earned $10 or more in interest on a CD, then those earnings must be reported. If the CD has a term longer than a single year, then you must pay taxes on the interest accrued each year.
Penalties for accessing funds early
When you sign up for a CD, you agree not to touch the money for a set period of time but there are always unexpected expenses. If you access your money before the CD’s term is up, you’ll be charged an early withdrawal penalty, often worth a few months of interest.
What you need to open a CD
- Social Security number for United States citizens or an individual taxpayer identification number (TIN) for others.
- Date of birth of the account holder. To prove your identity, you need to present documentation such as a birth certificate.
- A government-issued ID like a driver’s license or state identification card.
- Proof of address. This includes bills or a lease agreement.
- Contact information, such as a phone or email
- Information for the funding account, such as the routing number and account number.
The takeaway
A CD can be the right move if you have a low-risk tolerance and a shorter investment horizon.
To avoid the early withdrawal penalty, forecast your expenses and make sure you can commit to not accessing the funds for the entire term length. Remember that CDs aren’t the only option out there; take the time to explore other investments and create a well-diversified portfolio.
Frequently asked questions
Is it worth putting money into a CD?
For some people, it can be worth putting money into a CD. If a person is seeking a riskless investment with a modest return, CDs are a good bet—you’ll earn a higher rate than you would with a checking or savings account, but you’ll have to commit your funds for a fixed period.
What is better, a CD or IRA?
An IRA is a tax-advantaged investment account. Typically, investors can own stocks, bonds, CDs, and other assets through their IRA. In contrast, a CD is a deposit account where investors commit their money for a fixed period in exchange for a fixed interest rate. Typically, CDs don’t offer any tax benefits. An IRA is probably a better option if you're saving for retirement, but a CD is a good bet if you’re not investing for the long haul.
How much does a $10,000 CD make in a year?
The amount you earn on a $10,000 CD in a year depends on the APY and your federal, state, and local taxes. Hypothetically, if you deposit this amount into a CD with a 5% APY you will earn $500 minus the appropriate taxes.
