Fact Check Finance: A CD is better than a standard bank savings account
Fact Check Finance is an occasional series that puts common money assertions to the test.
“Don’t miss these red-hot deals!” shouts one bank’s poster with attractive CD rates in giant type. “Bank like a champion and open a CD today!” shouts another.
Recent bank ads sound like they’re hawking motor vehicles rather than savings vehicles. The reason: There’s souped-up competition among financial institutions to attract and keep your business, and banks are looking to lure you in with higher interest rates on savings products—including CDs (shorthand for “certificates of deposit”). “Banks use CDs as a way to bring in funds with a specific maturity date,” explained Greg McBride, chief financial analyst at Bankrate.com. The next time you pass the front window of any bank—or check out an online bank ad—you’ll see what I mean.
So does it make sense to jilt your old savings account to embrace a higher-paying CD? Read on to find out.
A tale of two accounts
A typical bank savings account—whether at a brick-and-mortar or online bank—is simple, versatile, and open-ended. It often requires no minimum deposit. You can put in or take out your money as needed (although there are limits on the number of transfers you can make per month). You can—and should—have a portion of your paycheck funneled automatically into one to build up savings. And generally, you’re free to close the account anytime—no strings attached.
None of this is true of a CD.
Both bank savings accounts and CDs are FDIC-insured and pay interest each month—with CDs historically and currently paying slightly more—but the similarities pretty much stop there. Think of a CD as a savings contract you make with the bank that comes with some unique features and rules. Here’s a rundown of what you need to know about certificates of deposit before you commit:
- They aren’t very liquid, meaning there are restrictions on putting money in—and taking it out. While some CDs have no minimum deposit, most start at $500 or more. Whatever amount you contribute to begin with will remain in the CD for the entire term, which is typically one to five years. You can’t make recurring deposits; if you want to add more money, you have to open a new CD. That means they’re not designed to be part of an automatic savings plan. That also means it’s a bad parking spot for cash you might need to get access to quickly.
As McBride points out, “CDs only make sense if you already have an adequate cushion for unplanned expenses in a liquid account.” (More on that below.)
That’s because withdrawing your money early will cost you a penalty of typically two to three months’ worth of interest, which could wipe away any earnings and then some.
- To make up for these restrictions, you get a fixed interest rate that often beats that of a savings account. A CD’s rate remains the same for your chosen term. It’s insulated from the economic forces—such as Federal Reserve decision-making—that can cause savings account rates to fluctuate. According to Bankrate.com and DepositAccounts.com, the best CDs currently pay more than 2%. Most rates for online savings accounts lag behind, recently dipping below 2%. Note that a few (mostly online) financial institutions offer savings account rates that beat CDs, but you may have to jump through hoops to avoid fees and get the best rate, such as making a minimum number of transactions per month on a linked debit card. (Two “with-strings-attached” examples: Green Dot bank is currently paying 3% on savings; Varo Money offers 2.8%.)
- Rates often vary depending on the amount you deposit and the length of your term. In some cases, you may not be in the “sweet spot”—for example, depositing $5,000 for six months—to get an appreciably better rate than that of a normal savings account. It can help to consider a specific purchase, like a car. If you want to put a down payment on a vehicle next May—six months from now—then parking the cash in a CD to get a better return makes sense. But if you might want to buy that car on Valentine’s Day—three months from now—stick with a savings account.
- You’re placing a bet on future interest rates. Say you open a two-year, 2% CD. Theoretically, if savings rates fall to 1% in six months (which, I should note, no one expects), you’re a winner with your higher fixed rate. If rates rise to 3%—which again, isn’t in the cards right now—you’re stuck with your 2% CD unless you pay an early withdrawal penalty. Which you shouldn’t. “Don’t chase yield and commit money longer than you can afford to as the early withdrawal penalty more than offsets the additional yield,” McBride said.
- A CD can help you avoid fees. One nice bonus: If you open a CD at the same bank where you have a checking account, any money in the CD may count toward your bank’s minimum balance requirement, sparing you the monthly checking account maintenance fee.
- Your CD may renew automatically. When your CD’s term ends, the money (including the interest) is often rolled over into a new CD. The bank will notify you about the renewal ahead of time, and give you a grace period, typically between five to 15 days, during which you can exit without penalty. Sometimes the renewed rate is lower than your original CD’s rate. So be vigilant, and move quickly to put your money elsewhere if your new rate is inadequate—or if you just need the cash.
Fact check verdict
No. Despite the breathless sales pitches, a CD isn’t always better than a bank savings account.
A certificate of deposit can be a good deal, but first you need to make sure you’ve covered all of your savings bases. Open a high-yield online savings account and build it up with funds automatically transferred from each paycheck. That’s your three-to-six-month emergency cushion—a top priority. Only then, if you can afford to lock up some extra savings for a year or more, consider opening a CD, with its slightly higher interest rate, for a short- to medium-term goal such as a wedding or a major vacation (or that aforementioned car). Likewise, if you have an old savings account that you never use, consider putting its balance in a CD for a few years so you can earn a little more.