Whether you’re just starting to build up your savings, or you’re a longtime saver and are interested in opening a new account, one of the most crucial decisions you can make as it relates to your savings strategy is where you’ll park your funds. There are a number of savings vehicles available to consumers that all function a little differently. Depending on what you’re saving for and whether it’s a short- or a long-term goal, your funds may be better suited for a certain account type over another.
Two of the most common deposit products are traditional savings accounts, which most banks and credit unions offer, and certificates of deposit (CDs) which are commonly offered as well but may not be available across the board.
What’s the difference between a CD and a regular savings account?
A certificate of deposit, or a CD, is a type of savings account that pays interest in exchange for setting aside money for a fixed period. The interest rate will not change throughout the term of the CD. Once it reaches its maturity date, you’ll have access to the amount you deposited, as well as the interest you’ve earned.
CDs come in a variety of term lengths—anywhere from a few days to 10 years. One-year, three-year, and five-year terms are the most common CDs offered across various financial institutions.
Savings accounts are a type of deposit account that usually pay interest on your funds, but allow you to make withdrawals without penalty (up to a certain limit). These types of accounts offer a bit more liquidity in case the account holder needs quick access to their funds. On the other hand, CDs lock in your funds and tend to charge a stiffer penalty for making a withdrawal.
Savings rates for these products also look a little different.
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Pros and cons of CDs
CDs offer a number of benefits for savers who are committed to leaving their money alone for a set amount of time, but for savers who are on the fence, putting money in a CD can be a risky move and incur hefty early withdrawal penalties if they suddenly need access to those funds. This is why it’s generally a good idea to have a goal in mind of the CD and the funds you’re putting into it. Having a specific goal in mind for that money, and an emergency fund in a separate savings account for when surprise expenses crop up, will ensure that you won’t be subject to any early withdrawal penalties and you still have savings set aside for short-term expenses.
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Pro: CDs tend to have higher APYs than traditional savings accounts. This can work with you or against you depending on when you open your CD. If savings rates are higher, your money will grow a lot faster. But if you open your CD when savings rates are on the lower end, your money won’t grow as much as it would have if you’d waited. “CDs and the terms of that deposit are between you and the issuer, typically with more limitations on when the funds are available to you than a savings account, but higher rates can be offered,” says says Doug “Buddy” Amis, a certified financial planner and president at Cardinal Retirement Planning in North Carolina.
Con: You’ll likely pay a penalty for making an early withdrawal. If you try to make a withdrawal before your CD reaches its maturity date, you’ll be responsible for an early withdrawal penalty. This penalty varies across account terms and financial institutions, but it could range from a few days’ worth of interest earned on the account or months’ worth of interest (which could mean losing out on all of the compound interest you’ve earned).
Pros and cons of traditional savings accounts
Savings accounts offer a lot of flexibility for consumers with the ability to make recurring deposits and penalty-free withdrawals. Depending on your savings goal, this kind of structure might be a better fit. However, savings accounts are not without their own drawbacks. Easy access to your money could tempt you to overspend and make it harder to build up substantial savings. Another drawback: fluctuating interest rates.
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Pro: Your savings will accrue interest. While savings rates for traditional savings accounts may be lower than other deposit products, it is still an interest-bearing account and will help your money grow more than it would if you left it sitting in your checking account.
Con: Savings rates can and will change. Unlike CDs, savers who opt for a traditional savings account don’t have the security of locking in a certain APY. “The flexibility of a savings account lets savers more easily move funds from savings to checking to spending, and some savings accounts support direct debiting like a checking account,” says Amis. “Unfortunately this flexibility comes with the lack of a guaranteed interest rate. Banks are able to easily change their savings account interest rates while CDs rates are guaranteed for the term of the certificate.”
How to choose between a CD and a regular savings account
If you’re not sure which account type is right for you, consider these three questions:
What is your savings goal? If you’re saving money for the purpose of a specific goal like purchasing a car, a CD can help you grow the amount you’ve saved and ensure that when the time comes to purchase your vehicle, you have enough money set aside to make the purchase. However, if your goal is to build an emergency fund with three to six months’ worth of expenses in it, you’ll need to have immediate access to those funds in the event that you do experience a job loss or some sort of financial hardship and need to supplement your income. In those cases, a savings account may be the more convenient option.
How much do you have available to put into your deposit account? Both account types can have minimum balance requirements, but not all CDs allow you to make additional deposits after you’ve funded your account. If you don’t have a good amount of money saved upfront, you might be better off choosing an account type that you can continue to add money to over time.
How might potential penalties affect you? Putting money into a CD means that you don’t anticipate needing your funds before your CD has reached its maturity date. Doing so could mean forfeiting all of the interest you’ve earned, or at least a good chunk of it. You typically won’t pay any charges on withdrawals from a savings account as long as you don’t make any withdrawals over the federal limit. However, if you find that you do have to go over the limit, most banks will charge between $5 and $10 per transaction.
It’s important to remember that having both types of accounts is a viable option if that’s what makes the most sense for your financial situation. If you have a mix of short-term and long-term goals, using a savings account to cover your short-term goals or emergencies, and a CD to supercharge savings goals that are further down the line could be a worthwhile strategy.
This story was originally featured on Fortune.com
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Source: https://finance.yahoo.com/news/key-differences-between-cds-traditional-164300145.html