By Mark Hollwedel | American Express Credit Intel Freelance Contributor
6 Min Read | February 1, 2022 in Money
Essentially, a CD is a savings account in which you promise not to withdraw your money for a certain amount of time. In exchange, the bank pays you a higher interest rate.
While CDs are federally insured and have fixed interest rates, it’s possible to lose money if you make a withdrawal before the CD’s maturity date.
If you’re saving for a particular goal or know you won’t need to withdraw your money for a certain amount of time, a CD might be a good investment because you could earn higher interest on your savings.
Figuring out the best way to invest your money means understanding all your options. In some scenarios, putting some of your money into a certificate of deposit (CD) can be a good investment choice. To decide, it’s important to understand the pros and cons of CDs and to match those against your personal investing goals.
A CD is a type of savings account offered by many banks and credit unions. With a CD, you generally invest a fixed amount of money for a fixed amount of time and receive a fixed interest rate over that time period.1 In other words, when you invest in a CD, you deposit your chosen amount of money for the term of your choice, usually ranging anywhere from three months to five years, and as long as you leave the money in the account the entire time, the bank will pay the promised amount of interest.
For example, imagine your bank offers a 12-month CD with an annual percentage yield (APY) of 5.00% and a minimum deposit of $500. If you invest $1,000 and leave the money in the account for the entire year, then at the end of the year your account will have $1,050.
Because CDs are savings accounts offered by a bank or credit union, they are insured up to $250,000 by one of two federal agencies: the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Administration (NCUA).2,3
While investing in a CD is virtually risk-free, the downside is that you can’t touch the deposited money until the CD’s maturity date. It is possible to lose money by investing in CDs if the money is withdrawn before the CD has earned enough interest to cover the cost of the early withdrawal penalty.
Most banks calculate the early withdrawal penalty based on a number of days of interest. According to a 2019 study, the average early withdrawal penalty for a 12-month CD was 120 days of interest.4 So, for example, if you were to withdraw money prematurely from the $1,000 12-month CD mentioned above, the penalty would be between $16 and $17, or approximately 120 days’ worth of interest at a 5.00% APY. Because the penalties can significantly decrease a CD’s earnings, you’ll want to avoid withdrawing your money early – especially because early withdrawal penalties have been increasing.5
One other potential issue to be aware of is that most CDs automatically roll over into a new CD with the same term as the previous CD – but most likely a different APY – a certain number of days after the maturity date. As a result, if you don’t promptly withdraw your money after maturity, the money may be automatically deposited into a new CD and you could be on the hook for an early withdrawal penalty.
Investing in a CD makes the most sense when the benefits of a CD align with your investment goals. CD interest rates tend to be higher than those of regular bank savings, checking, or money market accounts. The average 12-month CD offered 0.13% APY in December 2021, more than triple the average APY for savings and checking accounts and more than double the average APY for money market accounts at that time.6
There are three main scenarios in which it probably makes sense to invest your savings in CDs:
If you do decide to invest in a CD, it’s a good idea to look around at options from different banks and credit unions. Figure out what length of time you can afford to put the money into a CD, then find the institution offering the highest APY for that length of CD, as well as the lowest early withdrawal penalty.
CDs are a safe, secure investment option earning better-than-average interest compared to other types of bank accounts. If you have money that you don’t need access to immediately, you can probably earn more interest on that money by investing it in CDs than by leaving it in a savings account. But watch out for the penalties associated with withdrawing your money early. Used correctly, CDs can be a great way to invest your money with minimal risk of losses.
1 “Certificates of Deposit (CDs),” Investor.gov
2 “Insured or Not Insured?,” FDIC
3 “How Your Accounts are Federally Insured,” NCUA
4 “2019 Study of CD Early Withdrawal Penalties and How They Have Changed,” Deposit Accounts
6 “National Rates and Rate Caps,” FDIC
The material made available for you on this website, Credit Intel, is for informational purposes only and is not intended to provide legal, tax or financial advice. If you have questions, please consult your own professional legal, tax and financial advisors.