These days, it’s getting harder and harder to find a savings account with a good interest rate. Some banks’ CDs (certificates of deposit) offer slighter better returns if you’re willing to commit your money to the CD for the term of the certificate (often one, two or five years).
How CDs can (sometimes) help you save
Depending on your savings goals and other sources of cash, a CD may or may not be a smart move.
What is a certificate of deposit?
CDs are like savings accounts. They are federally insured, meaning they can’t lose value, so they are a totally safe place to put cash.
Unlike savings accounts and money markets, however, when you “buy” a CD, you can’t access that money anytime you want. If you withdraw money from a CD before the end of the term, you will pay a penalty equal to some or all of the interest the account has earned.
When not to use CDs
Because you face a penalty if you access your money before the end of the CD term, CDs don’t work for emergency savings or other money that you might need on short notice. (If your car breaks down, you want to tap your savings now, not in three months when your CD matures.) For this reason, I recommend everybody have at least six months of monthly expenses saved in a savings account before saving in CDs or other vehicles.
Also, young people should not use CDs to save for retirement. Many banks advertise that you can open your CD in an IRA. You may have read that you need to open an IRA to save for retirement and also noticed the ads at your bank. The only people who should be using CDs in an IRA are people in or very close to retirement who want to eliminate all risk from a portion of their nest egg. When you are young, you can afford to take risks investing in the stock market, so in your retirement accounts, you should do that.
When to save with CDs
A CD is an attractive option for saving for short-term goals. CDs can be a smart way to save for a major purchase like a new car, vacation, wedding or the down payment on a home. When saving for a short-term goal, you may be able to earn a better return on your money in stocks or bonds, but investing involves risk; with a CD, you know you’r principal will be there for you at the end of the term.
If, for example, you have been saving for home and know you will not be buying for another year, throw your savings into a 1-year CD to get a better return than you could in an online savings account.
Finally, if you are an aggressive saver and have at least two months of emergency cash and are working on building more, you can do what is called CD bracketing or CD ladders.
Say you are putting $400 a month into emergency savings. Once you have, say, three months living expenses saved, you can begin to buy CDs with different maturity dates. The goal is to think about what would happen if you needed your emergency savings in the future, and to have different CDs mature each month after your initial cash reserves has run out.
Now that savings interest rates are competitive with short-term CD rates, CD ladders don’t make much sense, but that can change if the spread between savings account rates and CD rates grows.