Certificates of Deposit (CDs) vs. Savings Accounts

Certificates of Deposit (CDs) vs. Savings Accounts
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After you have made the decision to start a savings plan, you have to decide where to put your money. Where you invest your funds depends on your savings goals, the need for access to the funds and interest rates.

Certificates of deposits and savings accounts are good, safe places to start, but each has its advantages and disadvantages. Let's look at the pros and cons of each and see how they would fit into your savings plan.

What Is a Savings Account?

A savings account is like having money in your bank checking account except that it pays you interest. The accounts are issued by banks and credit unions and are insured up to $250,000 by the Federal Deposit Insurance Corporation (FDIC) and the National Credit Union Association (NCUA).

You can open a savings account with small minimum deposits, although this amount varies from bank to bank, and you can add money to it any time you want. However, as far as taking money out, Federal Reserve Regulation D limits you to making only six withdrawals per month.

Interest rates on regular savings accounts are usually low. Rates at brick-and-mortar banks are typically low because of the expenses needed to support the building and other branch locations. Online banks don't have these overhead costs, so as a result, they're able to pay higher interest rates.

Banks will occasionally change the interest rates they pay for savings accounts in reaction to the economic environment, competition from other banks and their desire to attract more deposits. Even so, banks are slow to raise rates in a rising market but will be quick to reduce rates when the market turns down.

However, you can get significantly higher returns with high-yield savings accounts. These high-yield accounts typically require maintaining larger minimum balances, like $5,000 or more, but the return is substantially more.

Examples of online banks with good returns on high-yield savings accounts are Synchrony Bank and Citizens Access.

What Is a Certificate of Deposit?

A certificate of deposit is an account that pays a fixed rate of interest over a fixed number of months or years. Like savings accounts, the FDIC and NCUA also insure CDs up to $250,000.

CDs usually pay higher interest rates than money in a savings account. And longer-term CDs have higher returns than shorter-term CDs.

When you invest in a CD, you must be willing to give up access to your money until the CD matures, which could be several years. Another downside to CDs is their penalty for early withdrawal. If you have to withdraw your funds from a CD before its maturity, you will likely lose all or a portion of your accrued interest.

An in-between choice are no-penalty CDs. These are CDs that usually have maturities of 11 months or fewer, but the bank will allow you to withdraw all of your funds at any time before maturity without any penalties. The trade-off for this privilege is they pay lower rates, although the rates may still be slightly higher than the rate on a savings account.

The minimum amount to open a CD account ranges from zero up to $1,000 or more. For example, you can open a regular CD account at Bank of America for $1,000. But BOA will pay you a higher rate if you deposit $10,000 for one of their "featured" CDs.

You can open a CD account at an online bank with less money. Ally Bank, for instance, has no minimum required deposit.

When to Use a Savings Account

Savings accounts are best when you need liquidity.

To start, savings accounts are good for setting up three to six months of expenses as an emergency fund for unexpected bills, when you might need fast access to your cash. Certificates of deposit are not good for this purpose because of their penalties for making early withdrawals. .

After reaching that goal for an emergency fund, savings accounts are best when you need access to the funds in the near future to meet short-term savings goals. Examples of when you might need the money in a few months or a year would be saving money for a vacation, holiday shopping or buying a car.

The trade-off is passing up the opportunity to receive higher interest rates from CDs.

When to Use a Certificate of Deposit

Certificates of deposit are better for funds that you can afford to have locked up for a longer term of up to five years or more.

For example, you might have a five-year plan to accumulate money to make a down payment on a house. In this case, you could put funds into CDs with maturities of three to five years. You’ll also be able to plan better because you’ll know exactly how much interest you will receive and when, whether it’s in three years or five years.

Locking in a fixed rate in a CD is great if rates are going down. But what if rates are going up? In this case, you might end up with a lower return than if you had put your money in a high-yield savings account.

The solution to this dilemma is to create a CD ladder. This strategy involves opening several CDs with different maturities. Suppose, for example, you had $10,000 to invest. You could purchase a series of five CDs for $2,000 each, so that one CD matured each year in the next five years.

With this approach, you would have $2,000 maturing each year that you could roll over into higher interest rates. When rates start to fall, you will have CDs locked in at higher rates, giving you protection on the downside.

Your savings goals will determine the choice between a certificate of deposit and a savings account. For short-term needs, a savings account makes sense because you need quicker access to your money. On the other hand, if you want to receive higher returns and can afford to have your funds locked up for longer periods of time, then CDs are the better choice.

A well-balanced savings strategy would combine a savings account and a mix of CDs with varying maturity dates that align with your goals and need for funds. You don't have to limit yourself to either one.