If saving more money is on your agenda, there are plenty of ways to carve some extra cash out of your budget. The question is, where you should be stashing those dollars and cents?
Putting your money in a savings account is more profitable, and a lot safer, than leaving it under your mattress — but not by much when it comes to earning interest. As of mid-February, the average savings account was paying 0.56% in interest, which isn’t exactly going to make you risk.
Certificates of Deposit or CDs, on the other hand, can offer slightly better rates to help grow your savings faster. The national average for a one-year CD is currently 1.22%, with some five-year CDs offering rates of 2% or more. Interest-bearing checking accounts and money market accounts by comparison, are paying half a percentage point or less.
While CDs offer a step up in terms of rates, they do have some downsides that make them less convenient than a checking or savings account and less profitable than playing the market. Understanding their various ins and outs is a must before you dive in, especially if you’re new to investing. Here are some basics you should know before sinking money into CDs.
CD Basics: How They Work
A CD is a special type of deposit account offered by banks, credit unions and stock brokers. CDs are designed to offer investors a specific rate of return over time. These savings vehicles were first introduced in the 1960s and as far as interest rates go, they hit their peak in the 1980s, when five-year CDs were yielding just over 12%.
Changes in the federal funds rate have caused CD rates to decline since then. The federal funds rate is the lowest rate at which banks will lend money. When this rate goes up or down, so do CD rates. As of January 2017, the effective federal funds rate was 0.65%. The Federal Reserve rate is expected to increase the federal fund rate in 2017 and 2018, so looking ahead, CD savers could see a bit more payback on their investment.
Now for the nitty-gritty of how a CD works. A CD is a time deposit, meaning you’re investing the money for a set period of time. This is called the CD’s maturity term and it can be as short as three months or last up to 10 years.
When you invest in a CD, you’re committing to leaving your money in the CD until it reaches its maturity date. That’s different from a savings or money market account, which allows you to make up to six withdrawals per month.
The longer the maturity term, the higher the interest rate usually is but there’s a catch. To earn the full amount of interest, you have to leave the money in the CD until it matures. If you break into it early and withdraw your initial investment, the bank will penalize you by docking some of the interest you’ve earned. For that reason, a CD may not be a great choice for your emergency fund or any other cash you think you may need on short notice.