It’s important that you have cash in your bank account for things like emergencies or longer-term goals, such as getting married, buying a house, or saving up for college expenses. In today’s climate, though, there aren’t a lot of places you can stick your money where it will earn a very good rate of return, especially when you’re looking to avoid risk.
So in this article, I’m going to talk about CDs, and when (and why) they might be better than a traditional savings account. CDs do have value, and they allow your money to grow risk-free at a pretty good rate of interest. Let’s first break down some of the key differences between CDs and savings accounts.
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CDs vs. Savings Accounts
One of the ways that CDs and savings accounts are similar is that you can open them online or in a physical bank branch and earn interest (albeit, a small amount in many cases) on your principal balance. But frankly, that’s the only key similarity.
As we have seen recently with the rate cuts from the Fed, the interest rate you earn on a savings account can, and will, fluctuate up and down, based on where the Federal funds rate is at.
For example, rates last year were well above 2.00% APY as the economy was doing well and the Fed funds rate was higher. Lately, however, that has all changed and rates are in many cases just above a quarter percent. So the downside is you can’t predict what your rate will be.
Related: Best Savings Accounts For Kids
The upside to savings accounts, however, is that you can withdraw money whenever you want, up to your bank’s monthly limitations, so the money is more liquid. Plus, you won’t typically have a minimum balance requirement in your savings account (though some high-yield savings accounts do require this, so read the fine print).
CDs will tend to earn a higher interest rate than even a high-yield savings account (in MOST cases), and the nice thing is that the rate stays flat for the duration of the CD. This way, you know exactly what you’re getting in interest, even if it’s not much.
This could be considered a pro, but I can also see the argument on why it’s a con. Right now, for example, it’s great to have a guaranteed rate because we’re in a bear market. But if we were in a bull market, you might miss out on increasing rates for CDs, or even the ability to put that money elsewhere and earn an even higher rate of return (i.e., in stocks).
Also, with this guaranteed rate comes another downside–your money isn’t liquid. With a CD, you have to commit to a set period of time for the money to be tied up, otherwise, you may face a penalty or lose interest you were expecting. This window of time is going to vary, but in many cases will be at least six months, and often a year or two.
As another downside or limitation, CDs will often require that you deposit a minimum amount. This forces you to tie up even more of your savings than you would with a savings account in exchange for a better rate of return. Minimums usually aren’t crazy, though. Many CDs require a minimum of around $500 to $1,000.
Why Look at CDs Now?
CD rates tend to look more and more appealing during a bear market when stocks are getting pounded left and right. With the coronavirus, that’s where we stand today. The Fed has slashed rates and stocks are not exactly the safest short-term investment, which is why it’s a great time to consider a CD.
Plus it looks as if we’re heading for a recession that might hurt twice as badly as the 2008 Great Recession. Having peace of mind that your money is at least earning some interest during a time like this is reassuring.
We Recommend a Short-Term CD
It’s impossible to time or predict the market, despite what anyone says. Just read The Intelligent Investor, as Benjamin Graham tells readers not to get swept up in the odd behavior of “Mr. Market.” Think back a year ago when CD rates were higher (along with high-yield savings rates).
You may have thought, compared to what you could earn in the stock market, that the rate wasn’t worth it and that you could get more by investing (heck – I did!). Not only were we wrong, but we missed an opportunity to lock in what now seems like an unattainable rate.
And think about where we stand now. You might panic to buy a CD because you think things are only going to get worse–and they might, but they also might not. We just don’t know. Because of this uncertainty and volatility, we’ve found that a one-year CD is a pretty safe bet to get a good APY and not miss out on any huge upswings in the market.
For example, if you bought a 1-year CD today at 1.85% APY and the market suddenly turned around tomorrow (hint: it won’t), it’ll take a bit of time for the market to correct itself. So, you might be able to get a higher APY on CDs in six months.
A shorter CD won’t tend to balance the return with the benefit of having your money locked up for such a short time. It tends not to be worth it. And a longer CD causes you to miss out on potential gains in the market, versus being able to just buy another 1-year CD in a year.
Plus, a 1-year CD will often give you a better rate than you can get with even a “high-yield” online savings account right now. As of this week, my high-yield savings was slashed to 0.26% APY. I’ll take 1.85% on a 1-year CD over that any day.
Read More: The Best Interest Rates
When Does a CD Make MORE Sense Than a Savings Account?
I love the flexibility of a savings account, even at a reduced rate. But there’s still part of me that wants to maximize my earnings, even if it means locking up my funds for a while.
That said, you should ALWAYS make a decision that you can live with. If you are going to regret locking your money up for a full year then don’t do it. The extra change you might earn from interest isn’t worth the stress.
But to help you make a more informed decision here’s when I think a CD makes more sense than a savings account:
You Won’t Need the Money (and You’re 100% Sure)
A CD can definitely be valuable, as I’ve outlined above, but you have to remember that your money is going to be locked up. Yes, you can probably find a CD with no early withdrawal penalty, but you’ll be sacrificing APY for that.
Make 100% sure you aren’t going to need the money in whatever time window you’ve determined is best for a CD (again, I recommend a 1-year CD) before purchasing one. You don’t want to have to pay a fee to get your money back since that defeats the entire purpose.
If you’re not sure whether you can live without the money, try doing it for a month (or even a few weeks). Set it aside in a different savings account (or if you have Ally, put it in a different bucket) and see if you feel like you need to access that money. If you don’t, move forward and buy the CD.
You Already Have an Emergency Fund
I recommend always having three to six months of expenses worth of savings set aside in an emergency account. This should not be a CD since it’s not liquid enough, but rather a savings account.
So, if you already have that money built up and tucked away in a savings account, you’re in the clear in my book to open up a CD. Note that you shouldn’t be pulling money out of your emergency savings account to fund a CD. This should be “new” money.
As you can see, there are benefits to CDs now more than in recent years. Savings accounts are definitely a staple, but if you’re looking for something a little longer-term to balance out the risk in your existing portfolio, a CD is a great choice.