Certificates of Deposit 101

The sharp rise in interest rates manufactured by the Federal Reserve over the past year to address inflation has one semi-silver lining: you can now earn more interest on bank and credit union savings accounts, and certificates of deposit (CDs), if you shop smart.

I realize many of you may not be familiar with CDs. Ever since the financial crisis that began in 2008, it has generally not been possible to earn much of an APY on most CDs. That’s dramatically changed over the past few months, so let’s review what a CD is, when you might want to use one, and what type of CD might make sense for you.

CDs 101

A certificate of deposit you buy through your bank or credit union is fully insured, up to the FDIC and NCUA limits. It is a type of savings account, where you are guaranteed to get every penny you invested back, plus interest.

A CD operates a bit differently than a standard savings account.

• All CDs have a set maturity. You can purchase a 3-month CD, a 6-month CD, a 1-year CD, and even a 5-year CD. The interest rate at the time you purchase the CD is the rate you will be paid for the duration of the CD’s term. When the term is over, the money will be deposited in a checking or savings account you designate, or you can opt to reinvest the money in a new CD. There is no such fixed term for general savings accounts.
   
• The interest rate is fixed for the duration of the CD term. If you purchase a 1-year CD with a 5% APY today, you are guaranteed to earn that 5% APY over the ensuing 12 months, even if rates start falling three months after you purchased the CD. In simple terms: your interest rate is fixed for the entire term of your CD. With a regular savings account, the interest rate can change at any time. Just be aware that the “fixed” feature means that if you buy a CD today and rates increase, you will need to wait until the CD matures to reinvest it at a higher rate.
   
• You will owe a penalty fee if you cash out a CD before it matures. In CD lingo, maturity refers to how long the certificate will pay you interest. A 1-year CD has a 1-year maturity. Which means that it “matures” in 1 year. Once a CD matures, the principal (the amount you bought) and interest are yours to use any way you want, without any strings attached. But if you decide you want to cash out your CD before it matures, you will likely owe a penalty fee. The early withdrawal CD penalty fee is typically a month or two (or more) of the interest paid on the CD.

Choosing Your Term

Because money in a CD is a bit more tied up than with a basic savings account, you can earn more in a CD than in your savings account.

But you also have to think through what term makes sense. The longer the term of a CD, the more interest it pays. A 6-month CD will have a higher APY than a 3-month CD. A 1-year CD will have a higher APY than a 6-month CD.

If you think interest rates could fall from their current level, locking in a good APY today that you will be paid for a year, or more, is smart.

If you think interest rates may rise, a CD can still make sense, but you might want to consider a shorter-term CD of a few months, so you will be able to reinvest (rollover) the money into a higher-rate CD sooner.

There’s also a strategy called a CD ladder, where you buy CDs with different terms. That way, you always have a CD maturing sometime soon that can be reinvested. For example, if you bought a 3-month, a 6-month, and a 12-month CD you would have some money maturing every few months, which could then be reinvested in a new CD.

The other consideration is whether you already have a big chunk of emergency savings set aside in a savings account. That is still your first and most important savings goal. A savings account is what is referred to as being “liquid”: the money is yours to use whenever you need it, with no fees or withdrawal penalties for using the money.

You know what I am about to say: your goal should be to have one year of living costs set aside in a savings account at a federally insured bank or credit union (my favorite option is still Alliant Credit Union’s Ultimate Opportunity Savings Account).

But if you have that taken care of, and have more money you want to keep safe, a CD can make terrific sense. I think CDs can be a smart way for retirees to go: You know I think you should have a few years of living expenses set aside in safe savings (in addition to your regular emergency savings.) That’s what makes it possible to not touch your stock investments when the markets are down, and to give your stock investments time to recover from a bear market.

Three years is my recommended minimum for this extra retiree savings. If you want to be super safe you might consider keeping up to five years of living expenses set aside in a savings account. And because you won’t need to use all that money right now (that’s what your emergency savings is for) you could put this retirement savings account in CDs that will pay you even more than a regular savings account.

The same holds true for any money you want to keep safe, such as a recent inheritance you’re deciding how to invest/use, or if you sold a business or a home. But I want to be clear: CDs are not some magical solution for all your money. To have the best shot at earning long-term inflation-beating gains, you need to be invested in the stock market. But for the safe part of a diversified portfolio, CDs can be a smart complement to savings accounts.

Both banks and credit unions offer CDs. You might start researching offers where you currently have accounts. And then I encourage you to do some online comparison shopping, including checking out the CD opportunity offered by my great friends at Alliant Credit Union.

If you aren’t yet a regular listener of my Women & Money podcast, I hope you will start listening. I frequently share my advice on the best CD strategies based on what I expect may be happening with interest rates in the coming months.