Certificates of deposit (CDs) and high-yield savings accounts can help you reach your savings goals faster. Both are safe banking products that feature competitive rates, but how do you distinguish between the two? More specifically, which option is best for your financial situation? Here’s a closer look at both options, along with their key benefits and drawbacks, to help you make the right decision.
Understanding CDs vs. High Yield Savings Accounts
Below is an overview of each account option.
What is a Certificate of Deposit (CD)?
A CD is a type of savings account offered by banks and credit unions. It requires you to deposit funds and let them sit for a set period in exchange for a guaranteed rate of return. But if you pull funds before the maturity date, you’ll likely incur an early withdrawal penalty.
What is a High Yield Savings Account?
A high-yield savings account works like a traditional savings account but offers a much higher interest rate. They are more flexible than CDs, as you can pull funds at any time without incurring penalties. You can typically find the best rates on high-yield savings accounts through online bank accounts and credit unions.
Key Differences Between CDs and High Yield Savings Accounts
The following sections delve into the variances between CDs and high-yield savings accounts. More specifically, it looks at interest rates and terms, accessibility and liquidity, risks and guarantees, and tax considerations.
Interest Rates and Terms
Interest Rates: How Do They Compare?
CDs often come with higher interest rates than high-yield savings accounts. However, high-yield savings accounts have variable interest rates that could exceed the fixed rate you get with a CD, especially if the CD has a lengthy term.
Terms and Conditions of CDs
As previously mentioned, you’re required to leave the funds in a CD for a set period – typically between six months and five years – to earn the maximum return. Most CDs also require a minimum deposit that varies by financial institution.
Flexibility of High Yield Savings Accounts
Again, you’ll get more flexibility with a high-yield savings account since it doesn’t require you to tie up your funds for an extended period. You’re free to withdraw money whenever you need it. Keep in mind that these accounts may be subject to withdrawal limits.
Accessibility and Liquidity
Accessing Funds in a CD
The money you deposit in a CD isn’t accessible during the term. And if you do pull it out, you’ll be penalized.
Accessing Funds in a High Yield Savings Account
You can withdraw funds from a high-yield savings account at any time without being penalized. Keep in mind that some financial institutions impose monthly withdrawal limits that could result in penalties if you exceed the threshold.
The Impact of Liquidity on Financial Planning
Liquidity is a term used to describe how fast assets can be converted into cash. CDs are the least liquid option of the two since withdrawing funds before the maturity date comes at a cost. So, you’re better off parking funds for a future emergency into a high-yield savings account.
Risks and Guarantees
Risks Associated with CDs
As previously mentioned, CDs are subject to early withdrawal penalties that could eat into your savings should you need to access funds prematurely. And the fixed interest rate that comes with CDs means you could miss out on higher rates should market conditions change during the term.
Risks Associated with High Yield Savings Accounts
The variable rate on high-yield savings accounts means your earnings could be negatively impacted if rates dip. Furthermore, the interest earned on this type of account may not keep up with inflation, which could cause the value of your savings to erode over time. And there are also withdrawal limits with some banks and credit unions that could lead to costly penalties.
FDIC Insurance: What It Means for Both
Both CDs and high-yield savings accounts are usually FDIC-insured up to $250,000 per depositor, per bank. NCUA insurance extends to accounts held at credit unions. Either way, this coverage protects your hard-earned money if the bank fails.
Tax Considerations
Tax Implications of CD Interest
Interest earnings on CDs are taxed as ordinary income. This means it’s included with your other income and taxed at your usual rate. Even if you don’t withdraw interest, it’s still subject to taxation.
Tax Implications of High Yield Savings Account Interest
The same taxation rules apply to high-yield savings accounts.
Pros and Cons
Pros of Certificates of Deposit
- Higher earning potential: CDs offer higher interest rates, making it easier to grow your money faster.
- Fixed interest rates: Your interest rate remains the same for the CD’s entire term, regardless of market conditions.
- Low risk: CDs are FDIC- or NCUA-backed, making them a low-risk investment.
Cons of Certificates of Deposit
- Early withdrawal penalties: Pulling funds before the CD term expires will cost you.
- Limited flexibility: You can’t add money to a CD once it’s open, and early withdrawals come with penalties.
- Fixed terms: Fixed terms can become problematic if you need access to your money much sooner rather than later.
Pros of High Yield Savings Accounts
- Liquidity: You’re free to withdraw funds as needed without penalty.
- Higher rates than traditional accounts: You’ll get a greater return than you would with a traditional savings account.
- Easy access: Funds can be accessed through cross-account transfers, at an ATM or at a physical branch (if applicable).
Cons of High Yield Savings Accounts
- Variable interest rates: The interest rate can change over time, depending on the market conditions. This makes your earnings less predictable.
- Lower interest rates than CDs: While rates are higher than traditional savings accounts, they are generally lower than what CDs offer.
- Minimum balance requirements: Some accounts may require a minimum balance to earn a higher interest rate; falling below this amount could mean you’ll earn far less on your money.
When to Choose a CD
Ideal Scenarios for Choosing CDs
CDs are ideal if you have a lump sum of cash that you want to stash away and don’t need access to it for the foreseeable future. Again, you get a guaranteed return, assuming you don’t make an early withdrawal. And you’ll more easily resist the temptation to spend it to avoid the penalty.
Long-Term Financial Goals
CDs suit long-term goals like a down payment for a house or a future large purchase. Knowing your money is growing steadily can give you peace of mind. For example, if you know you’ll need funds for a child’s college education in five years, a five-year CD could be a smart move. It ensures your investment grows without the risk of market fluctuations.
Long-term CDs can also be part of a retirement plan. Placing a portion of your retirement funds in longer-term CDs can provide a stable, predictable return.
When to Choose a High Yield Savings Account
Ideal Scenarios for Choosing High Yield Savings Accounts
A high-yield savings account is great if you want a safe place to store your money while earning more interest than a regular savings account.
If you might need quick access to your money, this type of account allows you to withdraw funds without penalties. This is useful for unexpected expenses or financial emergencies. High-yield savings accounts are also usually FDIC-insured, providing security for your savings up to a certain limit.
Online banks often offer better rates because they have lower overhead costs. Consider opening an account if you are comfortable managing your finances online. Most accounts have no minimum balance requirements, making them accessible and flexible for various financial needs.
Short-Term Financial Goals
If you need to save for a short-term financial goal, you may want to consider a high-yield savings account. These accounts provide a balance between earning interest and maintaining liquidity. And you earn above-average yields without locking your money away for an extended period.
So, if you’re saving for an expense you’ll incur within the next year or so, a high-yield savings account is the better choice of the two.
