CDs: What You Need to Know
If you were a teenager in the 90’s, you might be hoping this article is about finding the best music of your youth. Although I’d like to be writing an article debating whether the Backstreet Boys or Green Day is the best musical group of the 90’s, this is actually an article about Certificates of Deposit. In case anyone’s interested, you should be listening to both bands, I’m a child of the 90’s, and you’d be mistaken if you don’t think 90’s music is the best music.
Okay, now for what we’re all here for, how do you choose which Certificate of Deposit is best for you? In case anyone isn’t already familiar, a CD is a form of investment where you earn a predetermined amount of interest in exchange for leaving your money in the bank for a predetermined amount of time. Each bank has their own set of rates that vary depending on the market, so it’s important to shop around when you are looking for a CD.
Rates for CDs will typically be higher than for savings accounts, because your money is more or less stuck in the CD until it reaches maturity. You can withdraw your money from a CD prior to the date agreed upon, but in most cases you will pay a penalty of at least a month’s interest, so if you can avoid doing that, you should. Except in the case I will outline later in this article.
Some banks are now starting to offer ‘breakable CDs’ which allow you to withdraw your money prior to the end of the term without a penalty at all. This can be a good option if you worry about needing your money sooner than you plan, or just don’t like the idea of penalties. You should be aware that once you withdraw your money, that CD is broken (not to be confused with a broken record, get it? Okay, moving right along here…) and if you want to re-invest, you will need to open a new CD, at whatever current rates are, so be careful about breaking a CD if you have a good rate locked in.
Depending on the market, banks will set different rates of interest for each CD term. For example, a 6 month CD might have an interest rate of 2%, a 1 year might be 2.4% and 2 years might be 2.6%. It is often (but not always) the case that longer terms mean high rates, that depends on a variety of factors which I won’t get into here.
Now for the exception I promised you about avoiding early withdrawal penalties. Let’s do a little thought experiment here and pretend you have $1,000 to invest and you plan to use it for a downpayment on a car in 3 years. You go to your local bank and they have a 3 year CD offering a rate of 1.4% or a 5 year CD offering a rate of 2%. If you play by the rules, then you might initially think you should go for the 3 year CD, since that fits your timeline for your car purchase. However, if you choose the 3 year CD, you are missing out on .6% interest each year for 3 years. In a case like this, it makes sense to do the math and see if the extra .6% you would earn annually by choosing the 5 year CD would outweigh the penalty you would pay by withdrawing your money at year 3 on a 5 year CD. I want to be clear that the math doesn’t always work in your favor, so it’s important to do out the math before you make your decision.
Here is a table to show you how the math works:
As you can see from the table above, after 3 years, you come out ahead almost $20 if you choose the 5 year CD. Let’s say, hypothetically, the 5 year CD has a 150 day early withdrawal penalty. As you can see in the table below, that 150 day penalty comes to just under $9, so in this case, you would still come out ahead if you chose the 5 year CD and broke it after 3 years.
In other cases with different interest rates, the numbers might not work out, so always be sure to check your math.
Now, I’m sure you are looking at the above table and thinking to yourself, ‘wow, an extra $10, better not spend it all in one place’. And I get that, $10 isn’t going to change anyone’s life, but if you extrapolate that out to a larger amount of money, you could be talking about some more interesting interest (see what I did there?). Also, are you telling me if I handed you $10 for no reason, you wouldn’t take it? Didn’t think so.