Ask a Nerd: When and Why Should I Open a CD? | Economic news

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The year 2022 has not been kind to our portfolios. But amid rising prices (i.e. inflation), there is at least one upside: Savings account rates have risen, including on certificates of deposit.

Some CDs have yields above 3% right now, but like any bank account, they don’t work for all financial situations. Let’s see if CDs make sense to you.

Quick definition: CDs that contain money, not music

If you came to this article thinking of a CD as a compact disc for music, I apologize – but good luck with your old-school music collection.

In banking, a CD refers to a certificate of deposit, which is a type of savings account with a fixed term and a fixed interest rate. You add money, wait for the CD’s term – usually three months to five years – to end, and get your money back with interest.

The main places to open CDs are banks and credit unions, which are the nonprofit counterparts of banks. Credit unions tend to call CDs “share certificates.” Brokers also offer CDs, but the process is more complicated and requires an investment account.

CD: the good, the bad, the pain

Good

Here’s the main reason to consider CDs: they can offer the highest guaranteed returns for a bank account. And current CD rates are among the highest in a decade, based on NerdWallet’s analysis of Fed data and its own data. When the Federal Reserve raises its rate, as it has done several times in 2022, banks typically increase their savings and CD yields.

By far, the best rates are at online-only institutions. At the time of writing, you can find rates for one-year CDs above 2.3% APR, three-year CDs above 2.7% APY, and five-year CDs above 3% APY. National average CD rates, on the other hand, are below 0.70%, which is even better than the national average of 0.13% on ordinary savings accounts.

Take this scenario: Put $10,000 in a 3% CD with a five-year term and you’ll earn about $1,600 in interest. Try the same amount and the same time frame, but in a savings account with a rate of 0.13%, and you will earn around $65. I would choose the first option.

Unlike some checking or savings accounts, CDs have no monthly fees or minimum balance requirements other than a minimum amount to open. High yield CDs have minimums ranging from $0 to $10,000.

The bad

CDs are the equivalent of a bank account to a safe deposit box. In exchange for high rates, you give up access to funds. The first time you add money is almost always the only time you add money, so you must agree to transfer a decent amount of money to an account beforehand. Then your money is locked in for the duration of the CD you choose.

The penalty

If you need to cash in on a CD sooner, well, that might hurt. You have to withdraw all the money in one transaction and almost always pay a penalty which can cost several months to a year of interest you have earned – or would have earned. A bank can tap into your initial amount to cover a penalty. Unlike other bank accounts, however, CDs only have one potential cost, and you can avoid it by waiting for a CD to mature.

When would CDs be best for me?

CDs have more specific use cases than your everyday checking and savings accounts. Ask yourself any of these questions before you decide to open one.

1. Do I need more distance compared to some savings?

Suppose you inherit an inheritance or some other kind of boon; or you have accumulated savings for years; or, you’re like my parents who, growing up, put savings in a stock certificate to keep it out of reach. Whatever the reason, a CD is designed to keep you from being tempted to spend those funds.

2. Do I have savings for a big purchase?

If you have money to buy a car or a down payment on a house in the next few years, a CD helps you set aside the funds until you’re ready.

3. Do I want to protect assets outside of investments?

CDs offer short-term security, not long-term growth. Funds are federally insured as they are in other bank accounts, meaning your funds are returned to you even if a bank fails. CDs also don’t have the risk of fluctuation in value like in the stock market.

CDs “sit the middle ground between emergency savings and investing,” says Derek Brainard, national director of financial education at AccessLex Institute, a nonprofit financial education organization.

Essentially, CDs are cash reserves for short-term goals. Emergency savings should be immediately accessible if needed, while investing — such as in stocks or bonds — is for accumulating long-term wealth, Brainard says.

What if the CDs don’t suit me?

Letting go of the idea of ​​high CD rates can be difficult, but you may realize that losing access to funds isn’t worth it. You can still take advantage of rising rates by opening a high-yield savings account. Like high-yield CDs, these accounts are primarily available at online-only banks and credit unions. Many have rates close to 2% APY right now, and you can add or withdraw money at any time.

I want a CD, but what if CD prices go up?

A CD’s fixed rate can be a double-edged sword: it offers guaranteed returns, but if rates go up, you lose higher rates after locking in yours. And rates have been rising lately.

“If you think the rising rate environment will continue, one strategy to offset that risk is certificate [or CD] laddering,” says CJ Pointkowski, assistant vice president of savings products at Navy Federal Credit Union.

CD laddering, or creating a CD ladder, involves opening multiple CDs of different lengths – usually short, medium, and long term. A common ladder consists of one- to five-year CDs where five CDs mature at staggered intervals, such as every year for the next half-decade. At the end of each CD, you can reinvest in a new five-year CD to take advantage of higher future rates – or you can withdraw the money.

If juggling multiple CDs seems complicated, another strategy is to open a CD without penalty. This less common type of CD allows free early withdrawal at any time after the first few days, removing any barriers to switching to a higher rate CD later. But rates alone shouldn’t guide your decision to open a CD.

“Ultimately, a CD will either be the right tool or not, regardless of what happens in the interest rate environment,” says Brainard.

Jack L. Goldstein