Why I Don't Love CDs -- Despite the Higher Interest Rates They Pay

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KEY POINTS

  • Certificates of deposit tend to pay higher interest rates than savings accounts.
  • They also come with restrictions that make them less attractive.

The upside often isn't worth it for me.

I'm a firm believer in having plenty of money on hand in the bank. First of all, everyone needs savings in case a financial emergency strikes, like a layoff or home repair. And also, when we're saving for near-term goals, investing our money can be a dangerous thing, namely because we risk losses. So it's a good idea to keep any cash you might need in the next few years tucked away in the bank.

But within the realm of banking, you have choices. You could put your money into a regular savings account. Or you could open a certificate of deposit (CD).

The upside of CDs is that they tend to pay higher interest rates than traditional savings accounts do. But despite that perk, I'm really not a big fan of CDs.

Not that much of a benefit

If your goal is to snag the highest interest rate you can on your money, then a CD may be a good choice for you. But it's also important to recognize that CDs come with drawbacks.

For one thing, with a CD, you're required to lock your money away for a predetermined period of time. That may be six months, one year, or longer. If you cash out your CD early, you risk a penalty worth several months of interest.

Also, while CDs commonly pay higher interest rates than savings accounts do, sometimes, their rates aren't that much higher. And so you're not getting a lot of financial benefit in exchange for having to commit to keeping your money where it is.

But perhaps my biggest gripe with CDs is that their rates can change from month to month. And so if you put money into a longer-term CD, you could end up losing out big time by being locked in to a lower rate.

Let's say you commit to a one-year CD paying 2% interest, and then three weeks later, you see that same CD term advertised at 2.4% interest. Suddenly, you've lost out on interest due to nothing but unfortunate timing.

Should you open a CD?

CDs give you an opportunity to earn more interest on your cash while it's parked in the bank. If you're saving for something like a down payment on a home and you know you won't be needing that cash for a couple of years or so, then you may want to put it into a short-term CD.

But be careful with longer-term CDs. Not only do you risk locking yourself into a lower interest rate, but you also risk getting penalized should you need that money in a pinch.

In fact, while a savings account is a great place for your emergency fund, you may not want to use a CD for that purpose. Granted, your principal deposit will be protected, and you can always decide that you'll just make your peace with a penalty of a few months of interest if push comes to shove. But I try to limit the extent to which I use CDs. And given the limited upside, you may want to take a similar approach.

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