If you follow certificate of deposit rates, you probably know that you can get around 5% APR at most major banks and digital accounts—which isn’t a bad deal for a guaranteed investment. Yes, you could invest that money in the stock market and hope for a higher return. But given the market volatility of the past few years and the current stresses of elections and recessions, it might make sense to go with the guaranteed option.
And that’s exactly what we ended up doing. Our household – that is, me and the man of the house – pulled our money out of the stock market years ago, realizing that record highs might not return for some time. With the goal of maximizing compound interest while avoiding market risk, we began investing our money in CDs with 5% APY and high-yield savings accounts with 4.5% APY.
I’m not a professional investment advisor, but I’ve been writing about personal finance for over a decade. I’m also pretty good at math, so I know that the difference between investing $50,000 in a savings account with 4.5% APY for five years and locking it into a CD with 5% APY for the same period is just over $1,500. We’d end the five-year period with $63,814.08 in the CD and $62,309.10 in the savings account, assuming annual compounding — and assuming, of course, that the interest rate on our savings account hasn’t changed.
That’s why we keep two years’ worth of all expenses in cash—the risk of the CD breaking and us having to pay a penalty isn’t worth the extra $1,500 we could earn if we could go five years without access to our emergency fund.
At this point, you’re probably thinking two things: First, that you may not have enough cash for two years of expenses. And second, that there are a handful of 5% APY CDs from reputable banks that currently only require a 10-month commitment.
Does this mean you should invest in a certificate of deposit?
Dig deeper: How much should you keep in a certificate of deposit?
Every CD has a break-even point
Whether you should invest in a CD depends on whether you expect the CD to be canceled – and whether your math skills are sufficient to determine the break-even point.
First, if you don’t have at least six months of expenses in cash, don’t bother with CDs. Put your money in a high-interest savings account and keep building your emergency fund.
But let’s assume you have an emergency fund sufficient to cover your household during a period of lower-than-usual income or higher-than-usual expenses. Let’s also assume you’re current with your tax-advantaged retirement accounts, including health savings accounts. At this point, you may consider putting your extra money into one of those 12-month CDs with 4.5% APY, assuming they’re still available—and you probably don’t even have to worry about the breakeven point, since the likelihood of you depleting your six-month E fund in the 12 months before your CD matures is extremely slim.
However, I know there are people who put part of their emergency fund into a CD, assuming they can live 12 months (or five years) without the money. I also know that after five months, some of those people will wonder if they should cancel their CD.
Of course, if you’re dealing with a true emergency where the need to get cash immediately outweighs all other options, you’ll rip up the CD and accept the penalty. (I’ve ripped up a CD before when I was younger and didn’t have such a good grasp of my financial future. It’s not the end of the world.)
However, if you are considering canceling the CD and choosing another option instead, such as taking out a credit card with a 0% introductory annual interest rate for 15 months and covering the costs that way, you should know whether you will achieve a profitable balance with the canceled CD.
Dig deeper: High-yield savings account vs. CD: What you should know about high interest rates
Early withdrawal penalties – and where to find them
Banks are required by the Truth in Savings Act to provide information about the various penalties for early CD withdrawals, although you may have to dig through the fine print to find these. In most cases, you’ll owe the bank a certain amount of interest back, regardless of how much interest your CD was earning before the withdrawal. This means that if you cancel a CD too early, you’ll end up paying the bank a portion of your original deposit.
How much you have to pay depends on the bank, the account and the fine print regarding interest.
For example, if you take out a Capital One 360 CD with a 4.50% APR for 12 months, you will have to repay Capital One three months’ interest if you cancel the CD early.
This means that the break-even point on this particular CD is three months. If you make it past three months without canceling the CD, you make money. If you cancel the CD before three months are up, you lose money.
On the other hand, if you take out a Synchrony Bank CD with a 5.15% APR for 9 months, you will only owe 90 days of simple interest if you terminate early.
Simple interest is the opposite of compound interest and is calculated based on the principal deposit only. The math gets a little more complicated here, and it’s probably easiest for me to tell you to just wait 90 days before canceling the CD, but there is one scenario where you might be ahead of the game a little sooner. Synchrony Bank also lets you withdraw the interest from your CD at any time without penalty – which, depending on your deposit amount, could help you cover an unexpected expense without too much extra cost.
To decide if a particular CD is worth it for you, check your CD’s terms and conditions and disclosures for details about early termination and penalties.
It’s also worth taking the time to review your financial situation and consider whether you’ll need the money before maturity. If you’re worried you’ll have to close your CD before the breakeven date, don’t make the deposit. Keep the money in a high-yield savings account and focus on other income-generating strategies.
Spending less is always an option, but I prefer strategies and tactics that allow you to improve your skills and make more money – which in many cases even surpasses the best guaranteed return.
Further reading: What is a CD ladder? How to create one – and lock in high interest rates before they drop
Frequently asked questions about certificates of deposit
Learn more about how certificates of deposit work, how your deposit is protected, and how to keep your money safe.
Are certificates of deposit insured by the FDIC?
Yes, CDs are insured by the Federal Deposit Insurance Corporation. The FDIC is an independent agency of the U.S. government that insures savings accounts, certificates of deposit, money market accounts, and other deposit accounts up to $250,000 to protect consumers from bankruptcy. Learn more about how to make sure your bank is insured by the FDIC.
What is a CD ladder?
A CD ladder is a savings strategy designed to spread your money across multiple CDs to take advantage of high interest rates without tying up your entire investment in one long-term CD. The result of the CD ladder is access to a portion of your investment at regular, timed intervals. Learn how to incorporate a CD ladder into your savings strategy.
How do banks make money with a CD?
Banks charge higher interest on the money they lend than they do on their customers’ deposits. The difference is called the spread, and it’s what banks rely on to make money. Unlike a traditional savings account, which allows you flexible money movement without penalty, a CD requires you to lock your deposit for a set period of time and will return your principal plus interest after the account matures. This lock-in period — and penalties that keep you from making an early withdrawal — allows a bank to better plan how long it can make money on your deposit, and it’s usually willing to pay a little more for that reliability.
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About the author
Nicole Dieker is an experienced freelance writer focusing on personal finance and personal development. Her expertise has been featured in Yahoo Finance, Newsweek, Bankrate, NBC News, Lifehacker, Penny Hoarder, The Simple Dollar, Vox, and other top media brands. Nicole also spent five years as a writer and editor for The Billfold, a personal finance blog focused on honest conversations about money.
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