CD or Savings Account: One, Both, or Neither?
Finding an investment product that best meets your unique needs can be confusing and frustrating. There are so many out there, including mutual funds, money markets, stocks, bonds, and annuities, to name a few. Books have been written comparing and contrasting each one of these. This article will focus on just two — certificates of deposit (CDs) and savings accounts. Given the current economy and the lower rates of interest, does either of these make any sense today?
Rather than list all of the factors that may go into your decision, let's focus on the major over-riding factor: risk. If I put my money in, will I at least get it out?
As a general rule, like so many things in our society, a low level of risk garners a small amount of gain; the higher the risk, the bigger the payoff. CDs and savings accounts are definitely in the first category, and they may be on the far end at that.
A savings account is created by depositing a sum of money into a bank or other financial institution, such as a credit union or savings and loan. The bank holds that money and may use it for lending. In return for the use of your money, the bank gives you interest. These rates trended up from the end of World War II through the 1980s. The rates between these time periods were anywhere from 7.5 to 10%. Savings accounts provided a secure means of saving and growing your money. However, since the 80s, interest rates have fallen drastically. The Federal Reserve Board notes that the rate now is 1.5% at best. While there is no one answer from economists, surely the fact that Americans are spending more, saving less, and accruing more debt has played a large part in this phenomenon. The only banking product that is currently used less for investment purposes is a checking account. Some checking accounts that maintain large balances continue to receive additional benefits, like free checks, overdraft protection, and minimal interest. Most, however, offer only the convenience of the easy use of your money. Even automatic billing and paying withdrawals from a checking account may now incur an additional fee.
The main drawback of savings accounts is their low interest rate, but they have several benefits as well. Money in savings accounts is thought to be one of the most liquid investments outside of cash, as you can get to that money easily and quickly. As long as your bank is open, you can walk in (or these days, access your account online or on your smartphone) and withdraw your money. If your bank is closed, you can still access your account electronically or via an ATM.
Money in savings accounts is insured up to $250,000 by the FDIC. This was instituted in the Depression when banks closed overnight and people were left with nothing. FDIC insurance doesn't, however, protect you from identity theft or the unauthorized use of your bank account.
Certificates of Deposit, or CDs
Consumers looking for another low-risk investment may consider CDs. A CD is a special kind of deposit account with a bank or thrift institution (a financial institution formed primarily to accept consumer deposits and make home mortgages, such as savings and loan associations and credit unions) that usually offers a higher rate of interest than a regular savings account. Similar to savings accounts, CDs are insured by the FDIC up to $250,000.
In exchange for the higher interest rate, consumers agree to deposit a set sum of money for a fixed period of time. This can range from one month to five years or longer. The bank pays the higher interest at regular intervals, usually monthly or quarterly.
When a CD reaches maturity, you receive your original investment and any interest that has accrued. To access your money during the term of the CD, you may face an "early withdrawal" penalty or perhaps forfeit a portion of the interest earned.
There are several types of CDs. “Traditional” CDs are still the most common. These CDs pay a fixed interest rate until they reach maturity, as described above. As consumers turn to other investments, many banks are offering a variety of CD products that have a range of non-traditional features. Some CDs have a nominal (or no) penalty for early withdrawals, special redemption features in the event the depositor dies, and terms that permit the bank to “call,” or accelerate a CD’s maturity. Many banks are also offering CDs with variable interest rates, called "index-linked," "market-linked," "equity-linked," or "structured" CDs. These rates can either be based on a pre-set schedule or tied to the performance of a specified market index (e.g., the Dow Jones Industrial Average).
The FDIC cautions consumers to make sure they understand all of the terms before investing in a CD. This includes reviewing the disclosure statements and all of the fine print. In particular, the FDIC says to do the following:
- Make sure you are investing in a CD from an FDIC-insured bank.
- Make sure that the CD's principal amount is not subject to any conditions.
- Ascertain the maturity date of the CD and whether there is an automatic renewal at maturity.
- Determine whether there are penalties for early withdrawal.
- Check to see if the CD has any call features. This means that the bank may choose to terminate or "call" the CD after only one year or some other fixed period of time.
- Determine whether there are any other features in the CD (like a death benefit).
- Consider “laddering” your CD purchases over different time periods to give you more flexibility in accessing your money. Rather than depositing a large sum into one CD, break the sum up and purchase smaller CDs that will mature on different dates.
Finally, the FDIC says to watch out for advertised CD rates that are much better than the competition. Most likely, there is a catch.
Both savings accounts and CDs are safe, insured investments that have very low risk. Look at how these products align with your needs. A CD may be appropriate if you have money that will not be touched for an extended period of time. If not, and if you are seeking more liquidity and higher returns, there are other financial products that may better suit your needs.