The savings account at your local bank probably earns around 0.5% interest right now. Even the best national banks at the moment earn only around 0.85% in interest.
By comparison, rates on CDs look pretty good. You can find five year CDs with rates around 1.80% if you search around.
A quick note for new readers: A CD is short for a “certificate of deposit,” which is essentially a special type of savings offered by a bank. It usually offers a better interest rate than a normal savings account, but you have to agree to not take your money out for a certain period of time – the term – or else you’re faced with a stiff penalty.
If you have $1,000 in the bank, 0.85% annual interest will leave you with $1,043.29 after five years, whereas a five-year CD at 1.8% will give you $1,093.30 after five years. That’s $50 more for every $1,000 you invest and they’re both equally stable.
So… why not get a CD?
Right now, I have no money at all in CDs and I won’t for quite a while. I don’t feel that earning an extra fraction of a percent in interest is worth all the drawbacks. Here’s why.
First, I can’t withdraw the money if I need it without incurring a stiff penalty. CD policies vary, but usually it amounts to six or nine months of interest on the CD vanishing if I were to withdraw early.
So, if I were to need the money before that mark, I’d lose much of what I’d gained by using a CD. In fact, if I use the money before the six or nine month mark, I’d actually lose money overall because the fee would be greater than the interest I had earned.
The only way to get ahead with a CD is to literally not touch the money for years.
Second, you have to get a long term CD in order to have a rate that’s noticeably higher than savings accounts. One or two year CDs have interest rates that are only tiny fractions of a percent higher than a savings account.
Let’s say, for example, that I’m comparing a 0.5% savings account and a 0.75% one year CD. I have $1,000 to save. Over the course of that year – when I’m unable to touch that money – the CD is only earning me $2.50 more than the savings account.
Third, if I get a long-term CD right now, will I still be happy with earning only 1.5% or something in 2017? Probably not.
The rates on CDs and savings accounts are largely based on the federal funds rate, which is a number set by the Federal Reserve (when you hear about “the Fed” and changing rates on the news, this is what they’re usually talking about). Right now, that rate is at 0 to 0.25%, which is basically as low as it can be. Banks only offer a little more than that.
Seven or eight years ago, that rate was around 4% and we saw banks offering interest rates as high as 5% or 6% on savings and even as high as 7% or 8% on CDs.
There are some reasons to buy CDs if the gap between savings accounts and CDs gets high enough, such as CD laddering, but you’d want at least a 1% difference between your savings rate and your CD rate.
Aside from that, the only reason to ever buy a long-term CD is if it’s high enough that you’re going to be happy with the return in four or five years. Since, right now, rates have pretty much nowhere to go but up, if you buy a long term one now, you’re going to just regret it later. Even if everything goes perfect for you, you’ve just barely beaten a savings account and you’ve had to lock up your money for that period.