In this high-interest-rate environment, yield has become anything but pedestrian. Certificates of deposit (CDs) and high-yield savings accounts are among the best places to save money right now. Both offer the opportunity to benefit from compound interest alongside backing from the federal government.
While these common deposit accounts can help you accomplish many of the same money goals, there are key differences. Here’s what you need to be aware of when comparing a CD versus a high-yield savings account.
What is a certificate of deposit (CD)?
A CD is a type of savings account that requires you to invest a set amount of money for a fixed period of time, ranging from 30 days to many years, in exchange for a competitive interest rate. An early withdrawal before a CD’s maturity date usually comes with a penalty fee. Also, many CDs require a minimum deposit.
When your CD term ends, you can take your money — initial deposit and accrued interest — or roll the proceeds over into a new CD. When your CD matures, you’ll typically have a grace period of seven to 10 days to decide what to do with your money.
Generally, the interest rate you receive increases commensurate with the length of your CD term, but that isn’t always the case. For example, at Marcus, rates do increase as you go from a six-month to nine-month to one-year CD, but they begin to decrease starting at 18 months and continue to decrease all the way until you reach a six-year term. Big, brick-and-mortar player Wells Fargo offers a 2.47% standard interest rate on a three-month CD, but only 1.49% for one year, as of April 2024. While this may sound confusing, it makes sense.
Amid uncertainty around interest rates, banks, especially the big ones, likely want to be careful about committing to offering too high of an interest rate for too long a period of time.
What is a high-yield savings account?
In most ways, a high-yield savings account works exactly like a traditional savings account. The big difference: high-yield savings accounts, usually offered by banks with a large or online-only presence, tend to pay higher interest rates than the standard savings accounts brick-and-mortar banks offer.
Pros and cons of certificates of deposit
Pros:
- You can usually find much higher rates than traditional savings accounts. Usually, CD rates are much more than the national average for savings accounts. If you have a large balance in a CD, it can grow quickly.
- Your returns are fixed. Another benefit is that your interest rate remains the same throughout the term of your CD. While rates on new CDs change frequently, you receive the interest rate you signed up for throughout your entire commitment.
- Your CD is likely insured. Through the Federal Deposit Insurance Corp. (FDIC), the U.S. government insures up to $250,000 per depositor, per FDIC-insured bank, per ownership category. If the bank that issued your CD fails, the FDIC makes good on the deposit, reimbursing you up to the $250,000 limit.
Cons:
- You can’t easily access your money. The bank expects you to deposit your money and then not touch it until your CD’s maturity date. A CD may not be a good choice if you think you might need quick cash for an emergency, for example.
- You could have to pay a penalty for early withdrawal. Banks generally charge an interest-rate penalty if you withdraw money from a CD before it matures. Early withdrawal penalties typically range from three months’ to one year’s worth of interest. These penalties tend to increase with the term of your CD. You can avoid penalties by choosing a no-penalty CD, but rates for that type of CD are usually lower. For example, The rate on Ally Bank’s no-penalty, 11-month CD, as of April 2024, was 4.00%, which is lower than the 4.50% on a similar, 12-month CD with an early withdrawal penalty.
- Your returns may lag behind inflation. CD rates can sometimes struggle to keep up with inflation. If you’re worried about missing out as interest rates rise, you could look into a bump-up CD. This type of CD will allow you to request a one-time rate hike if the rate increases during your CD’s term.
Pros and cons of high-yield savings accounts
Pros:
- Your investment is safe. FDIC insurance also applies to high-yield savings accounts.
- You can earn a competitive interest rate. Another advantage of high-yield savings accounts is high interest rates, relative to traditional accounts and, lately, some CD accounts.
- You can access your money when you need it. If you need to withdraw money from your high-yield savings account, you can typically do so without penalty. Some banks, however, may charge a fee if you exceed a certain number of monthly withdrawals.
Cons:
- Your account may have stricter standards than others. A high-yield savings account may require a minimum deposit or balance. Minimum deposits and balances can range from $5 up to thousands of dollars. Banks can charge fees or close accounts that don’t meet requirements.Your bank can also set transfer or withdrawal limits.
- Your interest rate can fluctuate. Annual percentage yields are variable, which means your yield may decrease in the future. The bank can change your rate at any time.
- You can find better options for long-term savings growth. Carefully investing in stocks can provide better returns if you want to grow your wealth for retirement and can tolerate a little risk. High-yield savings accounts tend to be geared toward short-term financial goals.
How compound interest works with both savings methods
As the Securities and Exchange Commission puts it, “Compound interest is the interest you earn on interest.”
Let’s say you deposit $5,000 in a high-yield savings account with a 5.00% interest rate and daily compounded interest. At the end of one year, you’ll have earned $256.34 in interest, resulting in a balance of $5,256.34.
Now the bank pays interest on $5,256.34. If rates remain the same, and you don’t deposit or withdraw any funds, you’ll have $269.48 worth in interest during the second year for a balance of $5,525.82. You can play with your own numbers using the SEC’s compound interest calculator.
CDs work similarly. Using our earlier example of $5,000 but invested in a one-year CD with a 4.25% interest rate, at the end of one year with monthly compounding interest, you’ll have $5,216.69 (your initial $5,000 plus $216.69 of interest). CD interest is generally compounded monthly or daily, but that factor will vary by bank.
When your CD matures, you might decide to take your proceeds and invest them in a new CD. At this point, you’re earning interest on $5,216.69 in your new CD.
In both CDs and high-yield savings accounts, compound interest can provide powerful results over time. An initial $5,000 investment that maintains a 5.00% interest rate over 10 years, and compounds monthly, turns into $8,235.05 thanks solely to the power of compounding interest.
Optimizing your savings strategy
Whether you put your money in a high-yield savings account or a CD, you can explore these strategies to take your savings to the next level:
Regularly add to your high-yield savings account. If you add $100 monthly to a hypothetical high-yield savings account with an initial $5,000 investment and 5.00% interest rate that remains constant and compounds monthly, you’ll wind up with $23,763.28 after 10 years. That’s a far cry from $8,235.05 from the example above, and all you had to do was save an extra $100 every month.
Use ladders to optimize CD interest. A CD ladder spreads your savings across multiple CDs with different terms and interest rates. Each rung on the ladder has its own interest rate and timeline, and a ladder can be structured in an endless number of ways to suit your needs, goals and preferences.
Starting with $10,000 to invest, a CD ladder could look like this:
- $2,500 in a three-month CD at 3.00%
- $2,500 in a six-month CD at 3.50%
- $2,500 in a nine-month CD at 5.00%
- $2,500 in a one-year CD at 5.00%
With this strategy, every three months — after the first three months — you’ll have access to $2,500 of your original $10,000, plus interest earned. If you need the money or you can invest it elsewhere at a better rate, you’re free to do so. You can also roll the proceeds of your expired CD into a new one, putting the power of compound interest into motion. You can structure CD ladders in many ways to suit your needs, goals and preferences.
How to open a savings account or CD
The process of opening a savings account or CD depends on the account and the bank. You can usually find the requirements and instructions on the bank’s app or website. First, you’ll want to round up the documents and information you’ll need to have handy. Here’s what most banks require when opening a new high-yield savings account:
- Driver’s license or government-issued ID:
- Social Security number or Individual Taxpayer Identification Number (ITIN)
- Proof of address, such as a utility bill
- Checking account information to fund the account
Fill out an application
Once you’ve gathered the necessary information, you’ll need to fill out an application for the savings account you want to open. You can usually find this on the bank’s website or mobile app. If the bank has physical branches, you may also be able to open your account in person.
On the application, you’ll provide information such as your full name, address and Social Security number or ITIN. Some applications can be approved immediately while others might take a few days.
Make an opening deposit
Not all savings accounts require an opening deposit. For those that do, you’ll need to fund the account when you open it. If you’re opening your account online, you’ll likely need to transfer money into the account from another account, such as a checking account. If you open an account in person at a branch, you might be able to make the opening deposit in cash or check.
The process of opening a CD is similar, though not exactly the same. You’ll still need to provide the same types of documents and ID, but you’ll also have to let the bank know what type of CD you want to open and the term length. Choices may include traditional CDs, bump-up CDs and no-penalty CDs. Depending on the bank, terms can range from three months to 10 years or longer.
Another difference is that while many high-yield savings accounts don’t require an opening deposit, you’ll almost always need to make a minimum deposit to open a CD. Most CDs require between $500 and $2,500.
How to choose between a high-yield savings account and a CD?
When deciding between a high-yield savings account and a CD, consider your priorities. If your goal is to lock in a high rate of interest on funds you don’t need to access for a period of time, a CD might be your best option. However, a high-yield savings account may be the better choice if you want to earn solid interest on your savings while still keeping the money relatively accessible.
While interest rates on high-yield savings accounts can often match or exceed CD rates, they are variable, meaning they can change at any time. This usually happens when the Federal Reserve changes the federal funds rate. This can make it more difficult to forecast the returns you’ll get over time, and it could also mean that an account that once paid out an attractive interest rate may quickly turn into a relatively average savings account. But high-yield savings accounts are more flexible than CDs. You can typically access your money easily when you need it, and many accounts don’t require you to make a minimum deposit or maintain a certain balance.
In contrast, CDs offer fixed rates that you can lock in for an extended period of time — regardless of the Fed’s action on overall interest rates. The main downside of a CD is that if you make a withdrawal before the CD matures you will likely get hit with an early withdrawal penalty. Another risk is that you could lock in a rate when interest rates are low. When rates go back up again, you’ll be missing out on the better return from the higher rates.
If you are weighing a high-yield savings account against a CD, consider your immediate financial needs. If you value liquidity and immediate access to the funds, you’re better off with a high-yield savings account. If you’re building longer-term savings for a mortgage or some other purchase, then a CD may be the better option. This is especially true when interest rates are high because you can lock those rates in for many years.
Frequently asked questions (FAQs)
It depends on how you define short term. If short term means three to six months, a three- or six-month CD with a higher interest rate than you can get on a high-yield savings account makes sense. But if you want access to use your short-term savings for an emergency or general spending — without early withdrawal penalties — you’re probably better off with a high-yield savings account.
As illustrated in this guide, you’ll pay an early withdrawal penalty if you take money out of a CD prior to its expiration date.You can avoid this penalty by going with a no-penalty CD, which tends to pay a lower interest rate than a traditional CD, or keeping your cash in a high-yield savings account.
Yes. The IRS considers earnings from CDs and high-yield savings accounts taxable income. If you received taxable interest income of $10 or more in a year, expect a 1099-INT form from your bank. Even if you don’t receive a 1099-INT, you are responsible for reporting this income.
The IRS treats interest income just like ordinary income. As with income from employment, you’ll pay taxes on interest income within your tax bracket.
You can’t add more money to traditional CDs after you make the initial deposit. However, you can generally contribute as much as you want, as often as you’d like, to a high-yield savings account.
Additional reporting by Vance Cariaga
