Thinking About Getting a 6-Month CD? Pay Attention to This Detail

If you're looking at today's certificates of deposit (CDs) by rate alone, you might notice a trend. Nearly all CDs with the highest rates have short terms, like six months. In fact, if you're looking at the best 6-month CDs, you'll see that most pay above 5%, with some even closer to 5.30%. In comparison, 2-year CDs are barely breaking above 4.5%.

That detail might lead you to open a 6-month CD. After all, six months isn't a lot of time to lock your money up. Plus, if you can earn 5.25% on your money for six months, you could generate a hefty sum by the time your CD matures.

True, the best 6-month CDs have mind-boggling rates. But be careful that you understand how your CD generates interest and what "APY" means. If not, you might be confused at how slowly your CD is earning interest.

Misunderstanding your CD's APY can lead to unrealistic expectations

Banks list bank accounts (CDs, savings, checking, and money market accounts) by their annual percentage yields (APYs). In a nutshell, the APY is how much interest a bank account will generate within a year. Since CDs earn compound interest, the APY also factors in the interest you're earning on interest you've already earned.

An easy way to understand how CD interest works is to look at a 12-month CD. A 12-month CD with a 5% APY would generate $500 in interest on a $10,000 deposit. This assumes that the account holder doesn't withdraw interest periodically or liquidate the account before its maturity.

Now, if you're in a hurry, you might see the 5% APY on a 6-month CD and assume you would calculate it like a 12-month CD. Not so. Because this is an annual percentage yield, you have to calculate your CD's earnings month by month to arrive at its total returns. Personally, I use CD calculators to do this, since the compound interest makes it cumbersome to work it out on paper. Using a calculator, then, we would see that a 6-month CD with a 5% APY would generate about $247 in interest on a $10,000 deposit.

Your CD may earn even less interest than you think

Another factor to keep in mind is taxes. Like with other savings accounts, you have to pay federal taxes on CD interest that totals $10 or more. What's more, you have to report CD interest for the tax year in which it was earned, even if the CD has multiple years. So if you had a 5-year CD, you would report the interest generated by the CD for each year until it matures. This is true even if you don't withdraw the interest.

If you live in a state with income taxes, you have to pay state taxes on your CD interest, too. This could make CDs slightly less lucrative than a Treasury bill with the same rate, as you don't have to pay state taxes on T-bills.

The only way around the tax liability with a CD is to hold one in a retirement account, like an individual retirement account (IRA). IRAs have the power of tax deferral, meaning you won't pay taxes on your interest immediately. That said, if you have your IRA at an online broker, you might be limited to brokered CDs, which aren't the same as bank CDs. Brokered CDs don't earn compound interest, but they can be sold on a secondary market like bonds.

All things considered, 6-month CDs are still paying out at incredible rates these days. Just make sure you understand how much money your CD is actually generating. No one wants to get to the end of their CD term and think, "Wait, where's my money?" In the meantime, you can check out some CD rates on our best CDs list and see if another term would suit your goals better.